The Political Economy of Financial Liberalization in South Korea: State ...

THE POLITICAL ECONOMY OF FINANCIAL LIBERALIZATION IN SOUTH KOREA State, Big Business, and Foreign Investors

Thomas Kalinowski and Hyekyung Cho Abstract This paper studies the political economy of financial liberalization in Korea. We highlight the primary importance of state intervention in promoting financial liberalization. We shed light on “power games” of state, big business, and foreign investors emerging in state-led financial liberalization, and their impact on the Korean economy. Keywords: financial crisis, financial liberalization, South Korea, IMF

Introduction The underlying idea of financial liberalization is that the free flow of capital leads to a more efficient allocation of financial resources and facilitates economic development. This idea is promoted by international organizations such as the International Monetary Fund (IMF), World Bank, Organization for Economic Cooperation and Development (OECD), and World Trade Organization (WTO). With this accelerated capital mobility, financial market volatility has been increasing since the 1970s. Consequently, financial crises have become more frequent and severe. Thomas Kalinowski is Assistant Professor in the Graduate School of International Studies at Ewha Womans University, Seoul, Korea. Hyekyung Cho is Lecturer in the Department of International Trade at the University of Incheon, Incheon, Korea. Thomas Kalinowski would like to thank the Korea Foundation for supporting the work on this paper. Email: , . Asian Survey, Vol. 49, Issue 2, pp. 221–242, ISSN 0004-4687, electronic ISSN 1533-838X. © 2009 by The Regents of the University of California. All rights reserved. Please direct all requests for permission to photocopy or reproduce article content through the University of California Press’s Rights and Permissions website, at http://www.ucpressjournals.com/reprintInfo.asp. DOI: AS.2009.49.2.221.

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The fiscal costs of resolving the crises have increased significantly, as have the political and social costs. The IMF, World Bank, and other proponents of financial market liberalization attribute these crises to market overregulation and “wrongly sequenced” market opening. They promote comprehensive market liberalization and investor-friendly policies as strategies to overcome financial crises. Since the 1997–98 Asian financial crisis, critical voices on financial liberalization have become louder. Stiglitz and Bhagwati are among the most prominent skeptics of the unfettered flow of capital.1 In this paper, we support this skepticism by analyzing the case of financial liberalization in South Korea before and after the Asian financial crisis. Financial market liberalization in Korea began in the 1980s and accelerated in the early 1990s. It facilitated huge inflows of foreign capital that eventually led to the devastating crisis. The problems of the first round of financial liberalization are well known and have been analyzed and criticized extensively.2 In this paper, we expand the criticism to the consequences of post-crisis financial liberalization. Since the crisis, the Korean government has embraced recommendations by the IMF and accelerated financial market liberalization. With its impressive macroeconomic recovery, Korea’s post-crisis financial reforms are seen as successful.3 The IMF praises Korea’s successful reforms by claiming that “ . . . the close cooperation between Korea and the IMF over the last few years has been exemplary and in many respects serves as a model for other countries.”4 We agree that the Korean economic stabilization and recovery were impressive, but we oppose the idea that financial liberalization played a crucial role in it—at least during the initial stabilization period in 1998–99. Financial investors only came back to Korea after the economy had been stabilized and reformed through massive government intervention. Since 1. Joseph E. Stiglitz, Globalization and Its Discontents, 1st ed. (New York: W. W. Norton, 2002); Jagdish N. Bhagwati, In Defense of Globalization (New York: Oxford University Press, 2004). 2. Chung H. Lee, Keun Lee, and Kangkook Lee, “Chaebols, Financial Liberalization, and Economic Crisis: Transformation of Quasi-Internal Organization in Korea,” Asian Economic Journal 16:1 (March 2002), pp. 17–35; and Eundak Kwon, “Financial Liberalization in South Korea,” Journal of Contemporary Asia 34:1 (March 2004), pp. 70–101. 3. David T. Coe and Kim Se-Jik, eds., Korean Crisis and Recovery (Seoul: IMF and Korea Institute for International Economic Policy, 2002); IMF, Republic of Korea: 2006 Article IV Consultation—Staff Report (Washington, D.C.: 2006); IMF, Independent Evaluation Office, The IMF and Recent Capital Account Crises: Indonesia, Korea, Brazil (Washington, D.C.: 2003). 4. IMF News Brief no. 01/82, “IMF Managing Director Congratulates Korea on Early Repayment of 1997 Stand-By Credit,” August 22, 2001, , accessed September 14, 2006.

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then, the share of foreign investment in the stock market, particularly the banking sector, has been growing, which we will analyze in more detail. Financial liberalization successfully put pressure on banks and corporations to improve their profitability. On the other hand, many problems of the Korean economy, such as sluggish corporate investment, can also be partly attributed to financial liberalization and the focus on shareholder value. More important, expectations that financial market opening would help to transform Korea from an economy dominated by family-owned business conglomerates (chaebol ) to a modern market economy did not materialize. Financial liberalization is much more complex than a simple free-market paradigm would expect. It reflects different political and economic interests competing and interacting with each other. Most important, the relationship between state and big business determines the path and configuration of the Korean financial liberalization. Financial liberalization is not a simple withdrawal of the state but is embedded in a dual process of embracing and dismantling the legacy of the former state-led development regime.5 Financial liberalization in Korea was facilitated by a bigger state with direct state intervention and state financing. Ironically, increased state intervention was the major catalyst for liberalizing and reorganizing the financial sector. In this paper, we go beyond describing the consequences of financial liberalization for investment and economic growth. Our primary interest is to compare and explain the political economy of pre- and post-crisis financial liberalization. We disprove the popular supposition that financial liberalization was the result of external pressure from the “Wall Street-TreasuryIMF complex.”6 Although external factors played a role in both phases of liberalization, we argue that the domestic political economy was pivotal, particularly in explaining the differences between the two phases. We show that post-crisis liberalization is qualitatively different from pre-crisis liberalization. Partial capital-account opening in the first round of liberalization served to convey the globalization strategy of the chaebol. The first round was an expansion of the Korean development strategy since the 1960s that protected the chaebol at home and supported them in their expansion on the world market, first through export and then through investment. The post-crisis liberalization since 1997 and the full-fledged liberalization of capital movements were the result of a counter-movement that aimed 5. See also Thomas Kalinowski, “Korea’s Recovery since the 1997/98 Financial Crisis: The Last Stage of the Developmental State,” New Political Economy 13:4 (December 2008), pp. 447–62. 6. Frank Veneroso and Robert Wade, “The Asian Crisis: The High Debt Model Versus the Wall Street-Treasury-IMF Complex,” New Left Review I/228 (March-April 1998), pp. 3–23.

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at curbing the power of chaebol by increasing the role of foreign investors. The second phase of financial liberalization was mainly a domestic political strategy of the Kim Dae Jung administration (1998–2003). Financial liberalization was at the heart of the entire post-crisis structural reform in Korea that was designed to transform the country into a modern market economy. This paper is organized as follows: The second section briefly describes the main features of the financial system in pre-crisis Korea and characterizes the first round of financial liberalization since the early 1990s. The third section discusses the financial crisis in 1997–98 and the following second round of liberalization, with a focus on the banking sector. The fourth section deals with the political economy of the reforms and analyzes the dynamics and interests behind financial market liberalization. The fifth section assesses the major positive and negative impacts of financial liberalization on the overall economy. Finally, the sixth section summarizes the contributions of our case study to the general discussion on the driving forces as well as the merits and problems of financial liberalization. In this context, we also reconsider the role of the IMF as one of the most prominent promoters of financial liberalization.

Round One of Financial Liberalization and the Financial Crisis During the high growth period of development from the 1960s until the 1990s, Korea's financial sector was tightly controlled by the authoritarian developmental state. Until the beginning of the 1980s, most banks were state-owned, and capital inflow and outflow were strictly regulated.7 State control over banks continued even after the banks were privatized in the early 1980s. Until the 1990s, foreign direct investment played only a minor role, while foreign credits were channeled into Korea via the state-controlled banking system. “Policy loans”—politically directed lending—were used as tools to finance the state-planned industrialization strategy, providing cheap credit to private corporations, especially chaebol. Thus, banks were an instrument of the state, used to achieve development, and not an independent business sector driven by market dynamics or profit seeking.8 The policy loans were not meant to create profits through interest payments but to boost industrial investment, exports, and growth. In return 7. For a critical analysis of financial markets in Korean development, see Meredith WooCumings, Race to the Swift: State and Finance in Korean Industrialization (New York: Columbia University Press and Studies of the East Asian Institute, 1991). 8. Because banks were the main source of financing economic growth in Korea, the government budget could be held balanced and government debt was kept at a very low level.


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for low interest rates, the state formally or informally guaranteed the loans and frequently bailed out companies and banks that became insolvent. As a result, bank bankruptcies were practically unheard of in Korea until 1997. This financial regime changed under the first democratically elected civilian President Kim Young Sam (1993–98).9 The Kim Young Sam administration shifted the focus from a development strategy that created and protected a domestic industrial structure to the segyewha (globalization) strategy that facilitated the globalization of the Korean economy. The segyewha strategy corresponded to the interests of the chaebols’ own international expansion. In order to institutionalize the globalization strategy of the Korean economy and bring Korea to the level of developed countries, the government applied for membership in the OECD in 1993 and finally entered this exclusive club of developed countries in December 1996. In order to become a member, Korea had to agree to financial market liberalization and, especially, opening the market to foreign investors. Thus, endogenous interests of chaebol, combined with exogenous pressure by international investors and the OECD to bring Korea’s financial markets in line with “international best practice,” led to the plan of a step-by-step liberalization of the Korean financial market. As a result, the Korean government began to loosen control over capital inflows and removed controls on short-term credit inflows while maintaining regulations on long-term credit inflow and equity participation. This policy served the interests of the chaebols’ strategy to become “global players” and provided them with easier access to international financial markets and the foreign credits needed to finance this endeavor. At the same time, the policy reflected the fear of chaebol families and the government about the increasing influence of foreign investors through long-term involvement and equity participation. In this sense, the first round of financial liberalization was still shaped by a preference for credit-financed development and by the bias against foreign direct investment that was characteristic of the Korean developmental state. Because of liberalization, the state lost control over the inflow of shortterm credit, but at the same time the actors still expected the government to guarantee private credit, just as it had done during the time of tight financial market control. The withdrawal of the state left the financial market in a control vacuum in which huge amounts of short-term foreign capital 9. For an overview of the financial liberalization in East Asia and Korea, see Ha-Joon Chang, J. Gabriel Palma, and D. H. Whittaker, Financial Liberalization and the Asian Crisis (Basingstoke, U.K.: Palgrave, 2001); Shalendra D. Sharma, “Intervention or Market Liberalization: The Korean Financial Crisis as a Case of Market Failure,” Progress in Development Studies 4:1 (2004), pp. 47–57.

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flowed into Korea. This capital was mainly channeled through the chaebolowned non-bank financial institutions (NBFI), which mushroomed in the 1990s. The NBFI were neither subject to the restrictions on chaebol involvement in the banking sector nor as closely monitored as the deposit-taking commercial banks. This liberalization and loose regulation were exploited by the chaebol-owned NBFI to borrow short-term from abroad and lend long-term to their sister companies. Equally important for the expansion of credit was the government’s withdrawal from active industrial policies, investment regulation, and supervision. The consequence was that the chaebol aggressively expanded and diversified their operations in fields such as steel and car manufacturing, where there was already an overcapacity in Korea. For example, Samsung entered the car market as Korea’s fifth independent carmaker despite serious skepticism from experts and bureaucrats.10 Hanbo, a medium-sized chaebol, entered the already saturated steel market. At the same time, the chaebol began to expand their presence abroad. They concentrated on risky investments in countries eschewed by established multinationals. Daewoo invested heavily in Eastern Europe, India, Uzbekistan, and Vietnam. Hyundai concentrated its investment in India, Southeast Asia, and Africa. The chaebols’ expansion into international markets was not only supported by the patriotic Korean public and international investors but also by renowned journalists and experts who participated in the discussion of the “East Asian Miracle.”11 Many scholars and journalists were eager to rationalize and legitimize the huge capital flows into East Asia. Because it was hard to assess the risks of a “miracle,” most investors just joined the herd and followed the stream of money. A seemingly unlimited credit supply further pushed the chaebol into their high-flying and high-risk investment plans. The vision of a dawning “Asian century,” which prevailed in international discussions at that time, made Korean chaebol as well as international investors euphoric and at the same time fearful of missing investment opportunities. From 1993 to just before the outbreak of the crisis in September 1997, Korea’s foreign debt rose from $44 billion to $120 billion. Although the level of absolute debt amounted to only 22% of GDP in 1996, the problem was that nearly 60% of the debt was short-term, i.e., with a maturity

10. For the changes in industrial policy, see Chang et al., Financial Liberalization, p. 145. 11. A famous World Bank study in 1993 was called “The East Asian Miracle.” See World Bank, The East Asian Miracle (Washington, D.C.: International Bank for Reconstruction and Development/The World Bank, 1993). The Far Eastern Economic Review featured the globalization strategy of Daewoo’s chairman Kim Woo Choong as the cover story on May 1, 1997. In 1999, Daewoo went bankrupt, and Kim had to flee Korea.


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of less than one year.12 In the third quarter of 1997, the short-term debt equaled 323% of currency reserves. Because short-term debt represents a direct claim on currency reserves, Korea depended on the frequent renewal of credit lines, which made the country extremely vulnerable. The crises in Southeast Asia that began in July 1997 and the collapse of some smaller and medium-sized chaebol in early 1997 triggered foreign investors to alter their assessment of Korea’s creditability, resulting in the withdrawal of their money. The sudden outflow of foreign capital rapidly reduced the foreign reserves, because the government had pledged to defend a fixed exchange rate to the U.S. dollar. By the end of November, the Bank of Korea (BOK) had used all its reserves unsuccessfully to defend the fixed exchange rate. The government had no choice but to float the Korean won and turn to the IMF for a stand-by credit. It can be concluded that financial market liberalization did not begin with the financial crisis and the IMF in 1997 but in fact played an important role in the origins of the crisis. The financial market liberalization up to 1997 can be characterized as a partial withdrawal of state control over capital inflows that was not accompanied by the necessary supervisory measures. This is often attributed to an unskillful or “wrongly sequenced” liberalization. On the contrary, we came to the conclusion that the first round of financial liberalization was implemented in this way because it perfectly reflected the interests of the chaebol. Chaebol could benefit from access to international financial markets, but long-term investment and equity participation of foreign investors remained restricted in order to protect the conglomerates against foreign influence. In a way, this kind of asymmetric integration into the international financial markets was an extended version of the mercantilist trade strategy of Korea up to the 1980s.

Crisis, Stabilization, and Liberalization, Round Two The 1997–98 Financial Crisis and Accelerated Financial Market Opening The second round of liberalization since the crisis of 1997–98 has a completely different political economic background. The second round began during the worst crisis in Korea since the end of the Korean War and proceeded throughout the following years of IMF structural adjustment and economic reforms. These reforms were conceived deliberately to transform the country into an open market economy. In November 1997, Korea's foreign reserves were exhausted because of the withdrawal of foreign credit, and the BOK was unable to defend the 12. See Chang et al., Financial Liberalization, p. 143.

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fixed exchange rate. In December 1997, the won lost nearly 50% of its value against the U.S. dollar. In 1998, the economy shrank by 6.9% and the unemployment rate rose to almost 7%.13 Unable to service its foreign liabilities, Korea was forced to ask the IMF for assistance. It received a bailout package of up to $57 billion—the biggest ever granted until then. The IMF tied its assistance to stabilization and structural adjustment measures to “regain the confidence of foreign investors.” It is important to keep in mind that the IMF interpreted the Asian crisis and the withdrawal of investment from East Asia as a “loss of confidence” in the crisis countries.14 The logical consequence was to implement “investor-friendly” policies, including removing foreign-entry barriers to the domestic market, applying high interest rate policies, and reducing direct state intervention into the economy. Based on this interpretation, which was also backed by the Korean government, the second round of financial liberalization began as part of the strategy to stabilize the financial system and overcome the crisis by attracting foreign investors. The most important reform measure was the complete opening of the financial market to foreign investors, including equity participation and investment in the banking sector. Before the crisis, individual foreigners were not allowed to own more than 7% of the shares of a Korean company and the collective foreign share portion was limited to 26%. In its first letter of intent to the IMF on December 3, 1997, the Korean government committed itself to raise both limits to 50%. In May 1998, the government abolished all ceilings on foreign shareholding and even allowed hostile takeovers— far more than the IMF had requested. As a result, the Korean financial market is now one of the most open for foreign investors. As part of this liberalization, restrictions on the nomination of foreign directors in financial institutions were also lifted. Liberalization also embraced other areas: dealings in foreign exchange,15 establishment of investment funds, purchase of public and corporate bonds by foreigners, access for foreign insurance companies, and many other sectors. Although the first round of financial liberalization was designed to serve chaebol expansion and therefore perpetuated chaebol-centered development, 13. For an analysis of the development of Korean labor relations, see, for example, Andrew Eungi Kim and Innwon Park, “Changing Trends of Work in South Korea: The Rapid Growth of Underemployment and Job Insecurity,” Asian Survey 46:3 (May/June 2006), pp. 437–56. 14. Given their confidence in the East Asian “miracle” before, it would be more adequate to attest a loss of belief than a loss of confidence. 15. An overview about foreign exchange market liberalization can be found in Yang Doo Yong, “Foreign Exchange Market Liberalization since the Korean Crisis,” in Young-Rok Cheong, Doo Yong Yang, and Tongsan Wang, eds., Financial Market Opening in China and Korea (Seoul: Korea Institute for International Economic Policy [KIEP], 2003).


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the second round was built around the interests of foreign investors and had a much more radical design. The aim of the reforms was nothing less than to change the engine of Korea’s economy from chaebol expansion to foreign investment, which became the new reference point for Korean policies. The promise of overcoming the crisis and stabilizing the financial market with the help of foreign investment became an important legitimizing factor for liberalization. For example, the social costs of the reforms were justified by citing the need to regain investors’ confidence. However, the promise did not materialize: foreign investors were not willing to risk investing in Korea. They waited until the government had done its work to stabilize and restructure the financial market. Stabilizing the Financial Markets: The Comeback of the State The short-term stabilization measures designed by the IMF to stabilize the financial markets and reverse capital outflow have been widely criticized because the prescribed austerity measures and interest rate hikes pushed many Korean companies into bankruptcy and deepened the crisis.16 However, in this paper we extend the criticism to the long-term reform measures of financial liberalization. Did financial liberalization help the Korean economy to overcome the crisis? Did financial-market opening induce foreign investors to bring their money back to Korea and improve international currency reserves and creditworthiness? We argue that the stabilization of the financial sector in post-crisis Korea cannot be attributed to financial liberalization but was achieved by massive state intervention. In 1998—despite the complete opening of the market and the high interest rates—there was actually a net outflow of portfolio investment of $1.05 billion and a $9.2 billion outflow of other investments (mostly credits). Only direct investment showed a slight positive balance of $0.51 billion. It should also be noted that most of the capital inflow in 1998 was attributed to the ability of the government to increase its debt level by borrowing money from the IMF and by placing government bonds on the international financial market.17 Thus, the inflow of foreign investment 16. For the initial IMF prescription, see the first letter of intent between the Korean government and the IMF (IMF letter of intent December 3, 1997, ). For a criticism, see, for example, the report of the IMF Independent Evaluation Office (IMF Independent Evaluation Office, Evaluation Report IMF and Recent Capital Account Crises: Indonesia, Korea, Brazil [Washington, D.C.: 2003]). 17. Most notably, the Korean government was able to place two government bond packages of together $4 billion on the international financial market in April 1998. See IMF, Republic of Korea: Economic and Policy Developments, IMF Staff Country Report, no. 00/11 (Washington, D.C.: 2000), p. 45.

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to the private sector was even worse, in negative digits. Portfolio and direct investment only picked up from mid-1999, when the financial and currency market was already stabilized. Currency reserves reached $62 billion in June and real GDP growth was 9.5%.18 Altogether net foreign capital inflow only amounted to 5% of currency reserve increases between December 1997 and the end of 2000, while exports accounted for 95%. Foreign investors only returned to Korea after the financial markets had been stabilized by state interventions, which were not part of IMF structural adjustment reforms. First, the government announced that it would guarantee all bank deposits in order to prevent a run on the banks by Korean savers. This kind of blanket guarantee was explicitly contrary to the idea of keeping the state out of the economy and avoiding “moral hazard.” In fact, the removal of direct or indirect government guarantees was part of the structural adjustment program negotiated with the IMF. Nevertheless, such a guarantee alone was not enough to stabilize financial markets. Governments of all the countries hit by the Asian financial crisis made such guarantees but only in Korea did citizens trust their government sufficiently: deposit guarantees in Indonesia and Thailand were ineffective because they were not seen as credible by the public. Koreans did more than keeping their money in the banks; many even sold their private gold reserves to the banks following a campaign launched by the government. The gold collecting campaign increased Korea’s currency reserves by an estimated $2 billion—more than the net inflow of foreign direct investment from the outbreak of the crisis in December 1997 until June 1999. The confidence of the citizens in the state played a crucial role in overcoming the crisis and was a necessary step for re-stabilizing financial markets. In the event of market turmoil, the Korean government was successful in mobilizing popular confidence in the state and using it to stabilize the financial markets. Second, in order to stabilize the financial sector over the long run, it was important to tackle the banks’ non-performing loan (NPL) problem, which was at the center of the crisis. In this regard, it was not foreign investors who came to Korea and saved the banks but the state itself that stepped in to rescue banks from the burden of rampant NPLs. In response to the crisis, eight commercial banks that became insolvent were nationalized. During the structural adjustment process, state ownership in the banking sector increased from 33% in 1996 to 54% in 2000.19 In general, state interven18. All the data in this paragraph were taken from the BOK online statistical database (BOK, Economic Statistics System, , accessed October 2, 2007). 19. IMF, Country Report Korea 2002 Republic of Korea Selected Issues (Washington, D.C.: 2002), p. 102.


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tion in the event of market failure is not inconsistent with liberal economic theory, except possibly for the most radical free marketers. However, we will see that the interventions were not just a short-term stabilization effort: the government became deeply involved in the mostly successful restructuring and managing of banks. Nationalization was a precondition for comprehensive financial liberalization and foreign entry into the Korean banking sector. In nationalizing troubled banks, the Korean government socialized the debt and spent additional funds to restructure the financial system. The public funds not only came from the state budget but also were channeled through two government agencies, the Korea Asset Management Corporation (KAMCO) and the Korea Deposit Insurance Corporation (KDIC), both of which purchased NPLs and recapitalized banks. Both agencies financed their operations by issuing government-guaranteed bonds. By June 2006, the government had spent 168.3 trillion won (approximately $176 billion)20 to stabilize the financial markets. This is equivalent to 28% of the Korean GDP in 2000. In terms of fiscal costs, the Korean crisis was one of the most expensive in recent history.21 State-led Bank Restructuring Until now, we have shown that state intervention was a decisive factor in restoring Korea’s financial stability after the breakout of the crisis, which contradicts the market-friendly approach regarding financial liberalization. However, this contradiction exists only under the notion that liberalization consists of a withdrawal of the state that liberates the "naturally existing" market forces “repressed” by state regulation. The contradiction can be resolved if liberalization is seen as a deliberate political strategy of reregulation. That was the case with the post-crisis financial restructuring in Korea, where the government mobilized the full spectrum of state instruments in order to implement its goals. From this point of view, state intervention to resolve the crisis situation was the precondition for the financial restructuring that followed. The increased influence of the state through banks’ nationalization made the restructuring process easier. The government first separated viable from non-viable banks in the ailing banking sector by using the Bank for International Settlements (BIS) capital adequacy ratio. Non-viable financial 20. At an exchange rate of $1 = 956 won (the average exchange rate of 2006). 21. The net costs of other financial crisis were as follows: Malaysia (1999–2001) 4%, Chile (1981–83) 34%, Indonesia (1997–) 52%, Thailand (1997–) 35%, Venezuela (1994 –95) 12.4%, USA (1984 –95) 2.1%, and Sweden (1991) 0% of the respective GDP. IMF, Republic of Korea: 2002 Article IV Consultation—Staff Report (Washington, D.C.: 2003), p. 14.

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institutions were closed and merged, reducing the number of commercial banks from 33 to 18 and other financial institutions from 142 to 127 in 2006.22 Most notably, the government merged four nationalized banks and several non-banking financial institutions to create Woori Financial Holding Company, Korea’s first financial holding company providing universal banking services, in April 2001. This move unleashed a merger wave in the banking sector. Because banks were closed and merged, the concentration in terms of assets controlled by the three biggest banks increased to 63% in 2005, up from 27% in 1997. Viable banks were refinanced by KAMCO’s acquiring NPLs. In 1997, only 13 out of 25 commercial banks in Korea met the capital adequacy ratio of 8% required by the BIS; the average BIS ratio was 6.2%.23 In 2006, the average BIS ratio in the commercial banking sector reached 12.3%. The share of substandard loans fell from 13.6% in 1999 to 0.2% in 2006.24 Restructuring was accompanied by a large-scale rationalization. The number of regular employees in the banking sector was reduced from 114,000 in 1997 to 66,843 in 2001, a decrease of more than 40% within four years.25 Since then, cuts in banking employment have been slowing. In 2006, the banking sector employed 66,561 regular and 31,715 irregular workers.26 It is not a great surprise that massive bank restructuring caused some of the largest and most intense protests by labor unions since 1997, which were often declared illegal and ended by the police.27 The government legitimized the use of force in bank restructuring by asserting the need to make banks profitable and attractive for foreign investors. Government officials claimed that these authoritarian measures were necessary to restore investor confidence in Korea’s faltering economic reforms. To tame labor unions, make layoffs easier, and improve labor market flexibility, the government also started to improve the social security net. The substantial increase in government welfare spending added to the costs of restructuring paid by the Korean taxpayer. 22. BOK, “Recent Financial Restructuring,” , accessed October 2, 2007. 23. Robert F. Emery, Korean Economic Reform: Before and Since the 1997 Crisis (Aldershot, U.K.: Ashgate, 2001); IMF, Republic of Korea: 2004 Article IV Consultation —Staff Report (Washington, D.C.: 2005), p. 36. 24. Korea Financial Supervisory Service (FSS), Financial Statistics Information Service, , accessed October 2, 2007. 25. Authors’ own calculations from OECD Bank Profitability, OECD, Financial Statements of Banks Statistics, . 26. FSS, . 27. “Strikes Protest Plan to Merge 2 Korean Banks,” New York Times, December 23, 2000; “Getting Tough: Seoul Sends in Helicopters to Help Bust a Strike and Convince Investors It Is Committed to Reform,” Asia Week, January 12, 2001.


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The post-crisis restructuring of the Korean banking sector consisted of an interesting mixture of comprehensive government bailouts, deregulation, and re-regulation. Its results are impressive. In 1999, the banking sector reported a 6 trillion won ($6.3 billion) loss. In 2006, its net profit reached 8.8 trillion won ($9.2 billion). Returns on equity rose to 15.6% from a loss of 23.1%.28 With such favorable data, it was no surprise that after the state-organized restructuring, the banking sector attracted the most buoyant foreign investments. Korea became “a great place to be a bank.”29 Bank Privatization and Foreign Investment At the heart of post-crisis Korean financial liberalization was the opening of the financial markets to foreign investors. Although restrictions on foreign entry into the domestic markets was removed in 1998, foreign investors did not come to Korea in the early crisis years. The Korean government’s efforts to attract the foreign capital needed to re-capitalize banks that were saddled with bad loans proved to be a failure. The lack of foreign interest in the Korean financial market became a big problem when officials envisaged the privatization of temporarily nationalized commercial banks. The government was committed to carry out re-privatization as soon as possible, because it had pledged to do so in accordance with the IMF memorandum and it intended to carry out profound structural reforms in order to transform Korea into a U.S.-style market economy. One of the huge problems of privatizing banks arose when the government wanted to sell its shares but there was not enough domestic capital to buy them. Theoretically, chaebol would have been potential domestic buyers, but this option was not politically viable. Since the 1980s, as difficulties in the government-chaebol relationship began to emerge, the restrictions on chaebol involvement in the banking sector have been the main political tool to confine their increasing power and to retain at least some government control over them—even though this often failed. The chaebols’ already overwhelming economic power and their responsibility for the crisis made it politically unthinkable to relax restrictions that banned the conglomerates from owning more than 4% of a bank’s equity. Thus, the government choice was to sell its shares in nationalized banks to foreign investors. Because initially there was little foreign interest in the Korean banking sector, selling banks to foreign investors was not easy. Since 1999, however, selling ailing assets purchased by KAMCO, including government shares in distressed banks, gained momentum. The foreign 28. FSS, . 29. “South Korea: A Great Place to Be a Bank,” Business Week, November 7, 2005.

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entry into the risky Korean market accelerated only as preferential conditions minimizing risks and guaranteeing secure returns for foreign investors were offered by KAMCO and thus, in the end, at the expense of the taxpayers. Hitherto, the largest foreign investments in the banking sector were takeovers by foreign buyout funds of three major commercial banks. Selling off nationwide commercial banks to foreign investors was a crucial event that allowed the Korean government to show international investors how open it now was. Because of financial liberalization, overall foreign shares in the Korean stock market increased from 14.6% in 1997 to 37.3% in 2006, although they dropped 4.7 points from the peak of 42% in 2004.30 Foreign investment is concentrated in a small number of big and profitable corporations like Samsung Electronics and Hyundai Motors as well as the banking sector, which showed the highest level of foreign ownership. In 2006, foreign investors held 65% of the stake in the entire commercial banking sector, a dramatic increase from 18% in 1998. Foreign investment stock as a percentage of GDP surged from 52% in 2001 to 73.4% in 2006.31 The increasing foreign entry into Korean markets, especially in banking, was seen as a key instrument to tackle “crony capitalism” and rampant corruption, and eventually to discipline the investment behavior of chaebol. While welcoming the growing influence of foreign investors, the government tightened regulatory measures to hinder reckless expansion by chaebol. The government’s reform objectives were widely accepted and supported by Korean experts as well as the public after a severe crisis occurred associated with chaebol mismanagement. That is why the government reform strategy worked smoothly without noticeable opposition, at least in the first years after the crisis.

Reform Coalitions in Post-Crisis Financial Liberalization In this section, we focus on the political economy of Korea, which can help us understand why financial liberalization turned out as described. Financial restructuring since 1997 was originally carried out under the mandate of the IMF. Indeed, the principles of IMF structural adjustment policies provided the basic institutional design and paradigm for restructuring. However, as we have seen, the Korean government used restructuring to 30. Korea Exchange (KRX), 2006 Facts and Figures Fact Book (Seoul: Korea Exchange, 2007), p. 40. 31. The figures are from 2001, calculated by the authors based on data from the BOK statistical database (BOK, Online Statistical Database, ).


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pursue its own agenda. Massive government intervention in favor of liberalization was the distinct feature of post-crisis financial reform in Korea. In order to understand the political paradigm of post-crisis financial liberalization, it is important to focus on the change in the political leadership and the democratic transition, both profoundly significant in postcrisis reforms.32 The unexpected victory of Kim Dae Jung in the presidential election in December 1997 in the middle of economic turmoil marked the first democratic formation of a government emerging from the opposition since 1945. The new administration embraced the IMF reform measures. There were congruencies in interests and ideologies between the IMF and the Kim Dae Jung administration regarding liberalization and the opening up of the Korean financial sector. The overarching goal of the governmentled post-crisis financial liberalization was to transform Korea from an authoritarian, chaebol-dominated economy to a democratic market economy, which had been the political credo of Kim, a former dissident.33 Having presidential power in his hands and using the crisis atmosphere, Kim Dae Jung was determined to turn his vision into reality. To realize his plan and give it legitimacy, Kim Dae Jung built a coalition, with the IMF and foreign investors as external powerful actors, and democratic non-governmental organizations (NGOs) as domestic partners. His vision was mostly in line with IMF advocacy for market liberalization. Identifying “crony capitalism” and overinvestment as the main causes of the crisis, the government’s post-crisis reforms were designed to punish and discipline uncontrollable chaebol business practices stemming from their monopoly of economic power in Korea. Because previous direct government action to curb chaebol power, namely, the “big deal”34 in early 1998, had proven ineffective, the government approached the issue indirectly. Given restraints on state power and the dominance of chaebol, the Kim Dae Jung government needed a strong, reliable counterweight to bring reform forward. By opening financial markets, the government established foreign investors as a new interest group and a counterbalance to the powerful, often still owner-family dominated, chaebol management. At this point, 32. For an analysis of the contradictory link among economic crisis, economic liberalization, and democratization in East Asia, see Thomas Kalinowski, “Democracy, Economic Crisis, and Market Oriented Reforms,” Comparative Sociology 6:3 (3rd quarter 2007), pp. 344–73. 33. Kim Dae Jung called his concept “mass participatory economy” that he said makes South Korea a leading economic power in the global marketplace. See Dae Jung Kim, Mass Participatory Economy: Korea’s Road to World Economic Power (Washington, D.C.: University Press of America, 1996). 34. The “big deal” was a government plan to reduce the diversity of chaebol. They were supposed to choose their core business and swap unrelated subsidiaries. However, the plan failed to materialize.

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we have one explanation why the government made such an effort to sell off some banks to foreign investors, seemingly at any cost. The domestic NGOs, which shared Kim Dae Jung’s vision of a democratic market economy and opposition to “chaebol despotism,” were also important reform partners arising from the middle class. Some influential NGOs such as People’s Solidarity for Participatory Democracy (PSPD), which organized minority shareholders, were very helpful.35 Their direct attacks against and sharp criticisms of chaebol appealed to the Korean public and enjoyed wide public acceptance. This created legitimacy for government reforms going in the same direction. Thus, public sentiment was favorably disposed toward the government’s neo-liberal agenda. The biggest domestic challenge to Kim Dae Jung’s reform agenda came from the labor unions. Kim focused on foreign investors and NGOs in order to check chaebol power. He opted for the model of U.S.-style shareholder capitalism but neglected the role of labor unions and employees in controlling management, a common feature in the German and Northern European forms of stakeholder capitalism. Although the improvements in labor rights were generally disappointing, the government still had to address the opposition; it did so in a politically sophisticated way. The government formed a tripartite commission of representatives from government, business, and labor unions, to jointly confront the crisis. Officials also legalized the Korean Confederation of Trade Unions (KCTU), an umbrella organization of independent unions, and recognized it as a participant in the tripartite talks. With the KCTU at last formally integrated into political decision-making, its resistance to government policy was restricted considerably. The government also promised to improve workers’ rights and extend the social safety nets for the unemployed. In return, the labor unions accepted economic liberalization and increasing labor market flexibility. In the early crisis years, chaebol were economically weakened by the crisis as well as blamed for and politically discredited by it. They were unable to resist the government’s vision of a “market democracy” with strong rights for shareholders. But government predominance and the unchallenged hegemony of the shareholder capitalism ideology were relatively short-lived. With the economic recovery beginning in 1999, the chaebol, reduced in number but increased in size, emerged from their previous defensive position. Their strong export performance, which contributed to the rapid economic recovery, made it clear that the government needed competitive chaebol to boost the economy. By earning foreign currency reserves through their exports, the chaebol were rehabilitated as the “savior of the economy.”

35. Thomas Kalinowski, “State-Civil Society Synergy and Cooptation: The Case of the Minority Shareholder Movement in Korea,” Korea Observer 39:3 (3rd quarter 2008), pp. 339–67.


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Since 2004, general skepticism about the painful reforms has soared. As nationalist sentiment resurged, public opinion turned in favor of chaebol. Taking advantage of this shift, chaebol launched an ideological counteroffensive to protect their dominant position, which was threatened by foreign competition in liberalized and open Korean markets. The power game in Korea was rekindled in a more complicated constellation. In addition to the long-standing tug of war between government and big business, other powerful players entered the scene: foreign investors. Today, the government stance toward both chaebol and foreign investors is ambivalent, swinging according to circumstances. The Korean political economy in the future will be mainly determined by the competing interests of these three players, as well as the still limited but growing political power of civil society and labor unions.

Consequences of Post-Crisis Financial Liberalization It is still too early to present a full evaluation of the consequences of postcrisis financial liberalization, but a preliminary assessment suggests that the full-scale financial opening up has produced ambivalent outcomes. The positive outcome came at the cost of a range of unintended negative consequences, but neither the great hopes nor the biggest concerns about financial liberalization materialized. The size and depth of capital markets have grown substantially along with the increased inflow of foreign capital since late 1999. Market capitalization as a percentage of GDP rose from 35% in 1998 to 97% in 2006. Foreign investors tend to have a stabilizing effect on the stock market because they take a longer-term perspective than domestic individual investors, although the overall volatility of the Korean stock market remains high. Financial investors have been successfully pushing for more profit-orientation in Korean business. Net incomes of the listed firms surged to 42.8 trillion won ($44.8 billion) in 2006 from 4.9 trillion won ($5.1 billion) in 2001. Return on equity rose to 12.2% from a meager 2.2% during the same period.36 The robust recovery, however, came at the cost of employment security. As secure and high-paid jobs were lost during the rationalization, newly created “irregular jobs” emerged that pay lower wages and provide little job security. Today, more than half of Korean employees are irregular workers with work contracts of one year or less.37 While foreign financial investors helped make the business climate in Korea more profit-oriented, they have not been able to change corporate 36. Korea Exchange, Fact Book 2003, p. 41, and Fact Book 2006, p. 45. 37. Regular employment was 53% in 2006 compared to 57% 10 years earlier, but up from a low of 48% in 2000 (Korean National Statistical Office, KOSIS database, ).

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governance in a significant way. The goal of the government to weaken the dominant role of chaebol and break them into independent corporations was not achieved. Although Hyundai, the biggest chaebol before the crisis, did break up into three “mini-chaebol,” this was the result of an internal struggle within the owner-family, not pressure from financial investors. Most chaebol, except Samsung, are switching to a holding company structure with intact, albeit weaker, ties among affiliates. In the field of corporate governance, the control of chaebol families over their groups remains largely unchanged. Among 51 business groups with more than 2 trillion won ($2.1 billion) in assets, 36 groups are controlled by the owner-family, even though shares owned by the owner and family members (including relatives) only amount to 4.61% of total shares.38 A complex structure of cross-shareholdings of affiliates enables owners with minority shares to control a group. So far, Korea remains the only major industrialized economy in the world still dominated by family-controlled corporations. The promise that financial liberalization would revitalize growth and investment was not kept. Despite the surprisingly rapid recovery from the crisis and the following surge in foreign investment, economic growth in Korea slowed markedly. The average GDP growth rate between 2001 and 2006 was 4.8%, compared to 7.7% from 1991–96. This was mainly due to sluggish investment. Gross fixed investment grew 3% between 2001 and 2006, down from 9.5% between 1991 and 1996. Fixed investment ratio as a percentage of GDP declined to 29.5% from 36.5% during the same period.39 Sluggish investment had two causes related to financial liberalization. First, ironically, the financial opening-up and increasing inflow of foreign capital did not increase, but played a role in reducing overall private investment. Much foreign direct investment was acquisitions, thus merely a change of ownership and not new “green-field” investments. More important, the pressure from foreign and domestic financial investors led to costly efforts by Korean corporations to increase shareholder value and to defend themselves against possible hostile takeovers, which impeded productive investment. At the head of this trend have been chaebol, as they seek to defend anachronistic family control over the group. Generally, domestic firms have become more concerned about their balance sheet and stock price, disregarding long-term investment.40 Instead, 38. “Chaebol Owners Still Dominate with 1.9 Percent of Shares,” Korea Times, December 27, 2004. 39. BOK, Online Statistical Database, . 40. See Jong-Hwa Lee and Changyong Rhee, “Crisis and Recovery: What We Have Learned from the South Korean Experience,” Asian Economic Policy Review 2 (June 2007), pp. 146–64.


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they primarily focus on reducing debt. As a result, debt to equity ratios fell from a notoriously high level of more than 400% in 1997 to an unnecessarily low level of 84.8% in 2006.41 Large domestic firms are also eager to bank retained earnings or use them to pay higher dividends and/or buy back their own stock. The dividend payment of publicly traded companies was 10.8 trillion won ($11.3 billion) in 2006, compared to 1.9 trillion won ($2 billion) in 1997 and 2.2 trillion won ($2.3 billion) in 2001. The dividend payout of the 50 largest firms in terms of market value accounted for about 80% of the total.42 Since 2004, the volume of stock buy-back amounted to 4.5 trillion to 7.6 trillion won ($4.7 billion to $8 billion) per year.43 This trend reflects not only a business standard conducive to “shareholder capitalism” but also a widespread fear of foreign hostile takeover. With the elimination of restrictions on foreign share ownership, domestic firms are exposed to this risk. Indeed, there have been a couple of hostile takeover attempts by foreign financial investors that targeted big corporations like SK Corp., Samsung Corp., and KT&G, Korea’s largest tobacco company.44 Domestic firms responded to potential foreign hostile takeover threats by hoarding cash. In 2006, the cash holdings of the listed companies accounted for 51.9 trillion won ($54.3 billion), of which 40% went to the five biggest chaebol. Along with that, corporate savings increased. Since 2001, corporate savings has outweighed household savings. Between 1999 and 2005, corporate savings more than doubled from 63.1 trillion won ($66 billion) to 132.5 trillion won ($138.6 billion).45 The private corporate sector, once the major borrower, has become a major saver and is now the largest contributor to high domestic savings of over 32% of GDP in recent years. As we saw in section 3, the post-crisis financial opening up led to increased foreign ownership, most notably in the banking sector. The desired effect was to strengthen the role of banks as independent profit-seeking businesses. Although this plan was successful, the banks’ role as financial intermediary institutions transferring savings into investment was affected negatively. The strong foreign presence in the banking sector, combined with market-oriented restructuring, weakened this intermediary role and 41. Korea Exchange, Fact Book 2006, p. 45. 42. Korea Listed Companies Association, Report to Dividends Payout of Listed Companies, Seoul, July 2007. 43. “Spending on Share Buyback May Backfire,” Korea Times, March 23, 2007. 44. “Hermes Faces Criminal Probe,” ibid., July 22, 2005; “Court Deals a Blow to Icahn’s Bid for KT&G,” International Herald Tribune, March 15, 2006; “Korea’s Debate on Foreign Capital Rages On,” Asia Times, April 11, 2006. 45. During the same period, household savings fell from 74 trillion won ($77 billion) to 50.9 trillion won ($53.2 billion) (BOK, ).

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altered banks’ lending behavior. The most conspicuous change was a sharp drop in corporate loans. Here, foreign-owned banks are trendsetters; they are leading forces in revamping lending practices and business behaviors of the domestic banking sector. Foreign-owned banks are most interested in asset stability and profits, combined with a conservative risk management strategy. Therefore, they are more cautious to provide credit for seemingly risky corporate investment. As foreign-owned banks began to cut corporate loans while aggressively expanding household and especially mortgage loans, domestic banks immediately followed suit, mimicking the foreignowned banks' lending strategies. The competitive expansion of household loans, driven by prevalent short-term-oriented and seemingly risk-averse lending strategies, facilitated an array of financial bubbles and subsequent crises: stock markets until 2000, credit card debts in 2002–03, and real estate from 2005 to 2008. The pre-crisis overextension of corporate loans was replaced by overextension of consumer and mortgage loans. A distorted resource allocation remained, jeopardizing the supply of funds for long-term investment needed for sustainable growth and development. Within the banking sector, this affected corporate financing. External financing in the private corporate sector involving bank loans, stocks, and bond issues fell from 67.5% in 1997 to 22.4% in 2005, while the share of internal financing increased from 25% to more than 80%.46 Direct corporate financing through capital markets—stocks and bond issues—continued to decline in absolute terms, from 92.5 trillion won ($96.8 billion) in 2001 to 44.4 trillion won ($46.4 billion) in 2006.47 This indicates that the intermediary role to provide funds for investment, of not only commercial banks but also the entire financial sector, has weakened substantially. The positive effects of financial liberalization are few and, in some sense, Korea now combines the negative aspects of shareholder capitalism with the negative aspects of chaebol capitalism. The country lacks both longterm investment because of short-term profit orientation, and also management supervision, because chaebol families continue to dominate. On the other hand, many initial concerns about financial liberalization were exaggerated. Financial markets today are not more vulnerable to financial crises than before the market opening, at least as long as a strong export sector continuously adds foreign currency reserves as insurance against external financial shocks. Korean financial markets can hardly be evaluated as stable, but the series of smaller boom and bust cycles since 1998 have so far not led to another major financial crisis. 46. See Jeong Seung Il, “Innovation-friendly Corporate Governance Structure and Financial System––Its Korean Form,” STEPI Policy Research Working Paper (November 2005), p. 111. 47. Korea Exchange, Fact Book 2003, p. 40, and Fact Book 2006, p. 44.


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Conclusions This case study of Korean financial liberalization contributes to a variety of controversial discussions on the driving forces and consequences of financial liberalization. First, we criticized the position held by the IMF and most liberal economists that financial liberalization is crucial to resolve financial crises by attracting foreign investment. We found little evidence that the accelerated financial liberalization since 1997 helped Korea to overcome the crisis. The significant reform measures for further financial liberalization and opening up were introduced at the beginning of the crisis. However, foreign investment initially did not help to stabilize Korea’s crisis-ridden financial markets. Foreign investors came back to Korea only after the government had stabilized the financial markets with taxpayers’ money, and after strong export growth earned sufficient foreign reserves. Our research suggests that foreign investors are reluctant to take risks during economic crises or turmoil. They show pro-cyclical investment behavior and herd mentality, which makes them an unlikely ally in turning around a crisis economy. Even if high interest rates promise high returns, foreign investors hesitate when macroeconomic stability is not guaranteed and risks therefore are too high. Second, we also departed from the prominent position of IMF critics that financial liberalization is mostly the result of pressure from the “Wall StreetTreasury-IMF-Complex.” We agree that IMF conditionality and international “best practice” played a role in pressuring for reforms, but these external factors alone are not sufficient to explain their concrete implementation. We showed that post-crisis reforms in Korea have been driven by a complex interaction of endogenous and exogenous interests. In order to illustrate the importance of the domestic political economy, we compared pre- and post-crisis liberalization in Korea. While pre-crisis liberalization was a partial deregulation that facilitated the expansion of chaebol, the second round of liberalization was directed against their power. The political economy of post-crisis reform revealed an interesting reform coalition consisting of the newly elected Kim Dae Jung administration, foreign investors, and anti-chaebol NGOs. In the beginning, the Kim Dae Jung administration managed to co-opt labor unions, which was unthinkable for previous conservative governments. The IMF and foreign investors provided the external pressure to form this coalition and the government used this pressure to mobilize wide public acceptance of the necessity for reforms. The reforms were legitimized by a mix of ideologies that involved a combination of democratization and market-oriented reforms. Third, we added evidence to the thesis that market reforms are not the result of mere economic developments and “laissez faire,” but are a form of state intervention. Financial liberalization during the crisis only worked

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because the state socialized debts and proactively restructured the financial sector. Since 1997, the IMF has acknowledged that premature and “wrongly sequenced” pre-crisis financial liberalization contributed to the outbreak of the Asian financial crisis. The IMF now promotes improvements in state regulation and monitoring of financial markets in order to facilitate liberalization. However, the IMF has done little to identify when and under which circumstances a country is ripe for financial liberalization and when it should be postponed. Our research suggests that a substantial amount of state capacity is needed to master financial liberalization, which limits its feasibility for many developing countries. Fourth, we concluded that promises that financial liberalization would fuel growth and development were exaggerated. In the case of Korea, it is still too early for a final evaluation of the consequences of financial liberalization, but it seems that neither the biggest promises nor the worst fears have materialized. Korea, so far, has not tumbled from crisis to crisis as many Latin American countries did after liberalizing their financial markets in the 1980s. As long as its export sector remains strong, Korea can buy stability through its currency reserves. On the other hand, the great promise that financial liberalization would lead to a new period of high economic growth and help to reform the anachronistic chaebol system was exaggerated as well. To some extent, Korea now combines the negative aspects of two worlds: the short-term profit orientation of financial market capitalism, and the lack of corporate transparency and management accountability of chaebol capitalism.

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