An internal U.S. Treasury memo written in early December summed up the unpropitious outlook for Indonesia, which was symbolized by a haze that had settled over much of Southeast Asia following an outbreak of fires in Borneo, Sumatra, and other islands. Suharto, the memo said, was “frustrated by the absence of any apparent improvement in Indonesia’s situation following the creation of the IMF program,” and it added: “Fears of social unrest are growing; ethnic Chinese ... fear backlash if times get rough, memories of massacres of 1965 remain strong. Financial crisis is compounded by drought, prospect of food shortages and uncontained forest fires. The political atmosphere, like the sky above Jakarta, is dark.”
The atmosphere was also dark 3,000 miles to the north, where another Asian economy was coming unglued.
5
SLEEPLESS IN SEOUL
In a televised address on November 22, 1997, Kim Young Sam, the president of South Korea, warned his nation to prepare for “bonecarving pain.” His words were well chosen. Korean financial markets were sliding into chaos, and the government had Just announced it would seek an IMF bailout. The following year, recession would shrink gross domestic product by 7 percent, wages for the average Korean worker would drop by 10 percent after adjustment for inflation, and the Jobless rate—in a country where lifetime employment was the norm—would climb to nearly 9 percent.
Five weeks before Kim’s somber TV speech, a team of IMF staffers had Just put the finishing touches on a confidential report that envisioned an entirely different scenario for the Korean economy. The document, dated October 15, 1997, minimized the chances that Korea would become engulfed by the sort of financial turmoil that had beset Thailand over the summer and had spread to Indonesia and Malaysia. The mission had been sent to Seoul to prepare Korea’s Article IV report, the annual assessment of the country’s economy. But the October staff report, instead of being submitted to the Executive Board in accord with the usual practice, was quietly stashed in the Fund’s files, because its findings were so quickly overtaken by events. The report stated in its opening section:The situation in Korea is quite different to that in Southeast Asia, and our assessment is that the weaknesses in the financial sector are manageable if dealt with promptly. While there are obvious risks, macroeconomic fundamentals remain strong and the current account deficit is narrowing toward a more comfortable range. External financing is certainly tight but we have confidence in the authorities’ ability to prudently manage the situation.
The report was not entirely rosy. Its authors fretted that “Korea’s vulnerability will remain high unless significant enhancements are made in the efficiency and soundness of the financial system.” They took note of problems plaguing Korean banks, which had been Jolted earlier in the year by several major corporate bankruptcies. Nonperforming loans were considerably greater than official estimates, according to the report, which reckoned that as of mid-1997 about 6 percent of all loans fell in that category—“a cause for concern, but not alarm”—and urged the Korean government to promptly pass financial reform legislation.
The IMF mission forecast growth of 6-7 percent for the Korean economy in 1998. “We have confidence in Korea’s ability to deal with the current difficulties,” the report concluded, “and believe that they provide an excellent opportunity for galvanizing broad based public support for the development of a more efficient and sound financial system.”
Clueless as it was, the IMF report provides a useful reminder that in stark contrast with the Thai case, where threats to stability had been apparent for many months before the collapse of the baht, the Korean crash struck like a thunderbolt. More than any of the crises elsewhere, Korea’s would show how swiftly and unexpectedly a nation’s economy—even one that has dazzled the world with its industrial prowess—can fall victim to the mercurialness of the Electronic Herd.
The first attempt to rescue South Korea (see Chapter 1) was launched over the Thanksgiving weekend of 1997. It was based on what U.S. Treasury officials liked to call the “Colin Powell doctrine.” This was a reference to the former U.S. general’s belief, made famous during the Gulf War, in the value of amassing an overwhelming force capable of defeating an opposing army quickly and decisively. It involved mobilizing a huge loan package in the hopes of quelling a financial market panic. Another key element in this IMF rescue effort was that the program went far beyond the typical austerity-oriented measures and aimed to fundamentally restructure Korea’s economic institutions, in particular the cozy links among the nation’s giant conglomerates, its banks, and the government.
But even as the High Command sought to forge a financial imitation of Operation Desert Storm, little did it realize how abruptly it would be playing the role of the Iraqi Republican Guard, routed and beating a hasty retreat.
Lest excessively harsh Judgment be rendered on the IMF’s upbeat Article IV report, it is worth bearing in mind that South Korea has a history of repeatedly confounding the doomsayers.
At the end of the Korean War in 1953, the population of South Korea consisted mainly of peasants living in thatched-roof huts. International food aid in the form of milk powder was handed out every few days in schools, and nobody saw much promise in the war-torn economy. Experts wrote off South Korea in the early 1960s as having one of the dimmest economic futures in East Asia; Burma and the Philippines looked as if they would be the region’s stars. Cambridge University economist Joan Robinson hailed the industrial development of Communist North Korea as a miracle and predicted it would economically overwhelm the “degenerating” South. Even in the 1970s and 1980s, when South Korean industrialization was leaping ahead, skeptics questioned whether the country could vault into the ranks of advanced economies. Although Korean manufacturers had shown they could move up the value-added chain from wigs, toys, and clothing to steel, petrochemicals, and shipbuilding, that did not augur that they could take on the mighty Japanese in global markets for products like autos and computer chips. But the chaebol, the conglomerates that dominate the country’s economy, defied the doubters time and again. Hyundai and Kia carved out respectable niches overseas for their cars, and Samsung achieved the stunning feat of becoming the world’s top producer of dynamic random access memory (D-RAM) chips, the silicon circuits that store data in every sort of electronic device imaginable.
A large part of Korea’s success was based on rock-solid fundamentals—a high savings rate, an education system that produced near-universal literacy, a society with an unsurpassed work ethic, and prudent management of fiscal and monetary policy. The other major factor was government intervention, which was aimed at building an export machine that could bring in the hard currency the resource-poor country needed to pay for imported oil and raw materials. The nation’s banks, instead of competing as market-based institutions, were used by the state for channeling peoples’ savings to the chaebol, with “policy loans”—credits granted at low interest rates to government-blessed projects—accounting for 60 percent of all loans in the late 1970s. Government bureaucrats set detailed targets for exports by product and market, and guided policy loans to firms that demonstrated their competitiveness, cutting off those that didn’t. Even though the bureaucracy relaxed its grip on the economy in the 1980s and 1990s, the line between government and private enterprise remained blurry, sometimes Jarringly so, as I learned in 1993 on a visit to Samsung Electronics’ computer chip fabrication plant in Kiheung, south of Seoul. I was interested in understanding how Samsung had succeeded at its risky plunge into chipmaking, and an executive vice president of the company, Lee Yoon Woo, explained that the policy loans the government had steered to Samsung were only a small part of the venture’s huge cost. What really mattered, Lee said, was that “the government wanted to support us” because Samsung considered itself to be “working for the government”—a statement no red-blooded American corporate executive would utter.
The Korean system, which was closely patterned after Japan’s, generated robust economic growth well into the 1990s�
��8.4 percent in 1994, 9.0 percent in 1995, and 7.1 percent in 1996—and the fruits were well spread among the nation’s 45 million citizens. By 1996, those former occupants of thatched-roof huts were enjoying annual per capita incomes of $11,400, nearly 100 times the 1953 level and two-fifths that of the United States.
Beneath the glitter of progress, though, the system was showing significant strains by the middle of the decade. The banking system had been denationalized and liberated to some extent from government control, but the Ministry of Finance and Economy still exercised influence over the selection of senior commercial bank managers. The banks also retained many of their bureaucratic characteristics, in particular a propensity to shovel loans almost indiscriminately to favored chaebol customers. The debt loads of publicly traded Korean companies were hair-raising by international standards, averaging more than 400 percent of shareholder equity. (U.S. firms, by comparison, average only a little bit more than a dollar in debt for each dollar in equity.) In part, this phenomenon reflected a tacit understanding among Korean banks that if their chaebol clients got into trouble, the bureaucrats would step in to protect everyone against calamitous loss, with a government bailout if necessary. Although heavy borrowing is sensible when the money is used productively, Korea’s overconfident tycoons were spending as if there were no limit to the world-beating facilities they could build. From 1994 to 1996, spending on new plants and equipment rose by nearly 40 percent a year. In some cases, these expansion programs reeked not only of excessive ambition but even megalomania.
The Ssang Yong Group, whose chairman, M. P. Kim, was a car buff (he once owned a fleet of twenty vehicles, including a Jaguar, BMW, Mercedes, Lotus, and Lamborghini), invested $4 billion to enter the Korean automobile market, where three giants (Hyundai, Daewoo, and Kia) already dominated. Samsung, whose chairman also cherished a personal car collection, insisted on following its rivals into the crowded automotive industry as well—and reportedly got permission from the administration of President Kim Young Sam by locating its plant in Pusan, Kim’s home base. The Halla Group, founded by Chung In Yung, the younger brother of Hyundai’s legendary founder Chung Ju Yung, built a state-of-the-art shipyard on Korea’s southwestern coast to rival the one run by the elder brother’s chaebol. All of these ventures would eventually prove ill-advised, but profitability was of little concern to these industrialists, for whom shareholders were a mere nuisance. What counted was size.
The costs of all this debt-financed, hell-bent-for-leather industrialization began to emerge in early 1997 as some of the most heavily indebted chaebol went bankrupt. The Hanbo steel group went belly up in January, the first bankruptcy among the top thirty chaebol in more than a decade. Compounding the shock was the conviction of Hanbo’s chairman and his son for diverting hundreds of millions of dollars from the group to bribe government officials and bankers in a maneuver to stay afloat. Next to go were Sammi and Jinro, followed in the summer by Kia, number eight in the chaebol ranks. The upshot of these soured loans was a substantial deterioration in the soundness of the banking system—not readily discernible, given Korea’s nebulous accounting practices, but evident even to the luckless IMF mission that drafted the Article IV report in October.
Still, it wasn’t as if Korea’s economy was rotten to the core. Its exports were growing at double-digit rates in volume terms, inflation was comfortably below 5 percent, and the government had run a budget surplus for three of the prior four years. In some respects, the developments of early 1997 could be interpreted positively, as evidence that Korea was finally tackling its underlying weaknesses. The government had formerly coddled the chaebol as if they were too big to fail; now it was allowing some of the biggest to go under. Kang Kyung Shik, deputy prime minister and minister of finance and economy, was an ardent reformer who vigorously resisted pressure to rescue bankrupt chaebol from their folly, and he was pressing legislation to modernize the regulation of the banking system. But whatever the grounds for positive sentiment, they would be overwhelmed by a series of events that began to surface on October 17, 1997—Just two days after the completion of the Article IV report—during a friendly game of golf.
The match took place at a golf course in Taipei, the capital of Taiwan, among a foursome that included Lee Kyung Shik, governor of the Bank of Korea, and Hsu Yuan Dong, governor of the Taiwanese central bank, which is called the Central Bank of China. The two bank chiefs spoke English with each other, but Hsu was conducting frequent, agitated conversations in Chinese over his mobile phone. “I knew it was something urgent, but I didn’t know what,” recalled Lee. “I thought, ‘Is it a personnel issue?’ I didn’t know.”
Although Lee said he didn’t expect to be told, it is astonishing that his golfing partner did not inform him of events, because the implications for the Korean economy would prove devastating. As Lee learned the next day when he returned to Seoul, Taiwan had decided to abandon its policy of defending the value of its currency, the New Taiwan dollar, against the U.S. dollar, and would allow it to fall. Because Taiwanese products compete closely with Korean products on global markets, the move would undercut the price competitiveness of Korean goods—and that in turn would put enormous pressure on the Korean won. The forces of financial contagion were reaching northward and infecting the Korean economy.
Up to that point, contagion had been largely limited to Southeast Asia. Frustration among the Asians over the phenomenon was much in evidence at the September 1997 annual meeting of the IMF and World Bank in Hong Kong, where Malaysia’s fiery Prime Minister Mahathir denounced currency trading as “unnecessary, unproductive, and immoral.” But on the whole, the mood at the meeting within the High Command was one of relief that the crisis had not spread further. “There was lots of complacency [at the meeting],” recalled a senior European official. “People thought Thailand was well contained; the general perception was that things were well under control, and Thailand was a special case.”
The causes of contagion are still a subject of considerable mystery and controversy among economists, but in Asia, several factors appear to have been at play. One is trade-related: The plunge in the Thai baht, by making it possible for Thai exporters to sell their goods more cheaply, reduced the competitiveness of similar goods exported by neighboring countries—so foreign exchange traders figured those countries’ currencies would be dragged down too.
A more likely explanation for the contagion is financial—that is, the tendency of lenders and investors who find themselves facing losses in one country to start reducing their holdings in similar countries. Partly, this is attributable to what economists call the “wake-up call” phenomenon, in which members of the Electronic Herd start taking note of ominous parallels between a crisis-stricken country and other, similar countries. Partly, it is attributable to herding behavior, in which portfolio managers follow their competitors’ investing patterns lest they be blamed for failing to spot a trend that was obvious to everyone else. But in Asia, even more powerful factors may have been at work.
Carmen Reinhart, the former IMF economist who visited Japanese banks when they were lending heavily in the region, compiled evidence showing that those same banks played a major role in fomenting contagion there. A study coauthored by Reinhart, who is now at the University of Maryland, revealed that Japanese banks scrambled to cut their loan exposure after the devaluation of the Thai baht. “People tend to think of ‘hot money’ as mutual funds, or hedge funds—which, of course, it is,” Reinhart said. “But in Asia, bank lending was the key form of hot money.” Although banks make long-term loans for specific projects, they also commonly make short-term loans to other banks, typically a couple of weeks to a few months in duration, in what is called the “interbank market.” Under normal conditions, these loans are routinely “rolled over,” or extended, when they expire. But once the crisis started, much of the rolling-over stopped; in other words, “Banks were saying, ‘Not only will I stop new lending; you have to repay what you owe me today,’” Reinha
rt said.
Having been Asia’s major capital suppliers, banks were also the largest capital withdrawers in 1997 and 1998, Reinhart noted, with the Japanese doing it earliest and in the greatest quantities. Japanese banks held $97 billion in loans to the five Asian countries hardest hit by turmoil—Thailand, Malaysia, Korea, Indonesia, and the Philippines—four times the amount lent by U.S. banks. Moreover, Japanese banks were most exposed to Thailand, where the crisis started, and as the deterioration in the value of their Thai loans hit their balance sheets, they became the first to pull out of Asia, calling loans elsewhere and cutting their exposures to the region by more than $10 billion between June 1997 and December 1997. European banks had lent large sums ($85 billion) to these five Asian countries, too, but most of their exposure was in Korea, and they began withdrawing from the region only after the Korean crisis had started. In the end, all rich countries’ banks contributed to the problem. “Even if the banks were not the immediate trigger of financial contagion, their actions certainly made the spillovers, first from Thailand and later from South Korea, far more severe than they would otherwise be,” concluded a 1999 study by Reinhart and Graciela Kaminsky of George Washington University.
Loans from foreign banks were indisputably Korea’s Achilles heel. In contrast with Thailand’s case, foreign capital inflows had played a modest role in the growth of highly protected Korea; Seoul maintained tight ceilings on foreign stock and bond purchases, for example. But Korea opened its financial system in the early 1990s to permit greater borrowing from foreign banks, and Korean banks usually did the borrowing on the interbank market, taking advantage of lower interest rates overseas and passing the funds on to their domestic customers. This was hardly prudent banking practice, since it meant that Korea Inc. was borrowing short-term money abroad—money that had to be repaid in hard currency—and lending it long-term to the expansion-crazed chaebol. Nevertheless, foreign banks rushed into this promising new market, led by the Europeans and the Japanese. From 1994 to 1996, Korea’s liabilities to foreigners soared by more than $45 billion.
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