The Chastening

by Paul Blustein

  All of this financial maneuvering suddenly became a serious problem amid the firestorm that followed the depreciation of the New Taiwan dollar on October 18. The shock waves hit first in Hong Kong. Traders reasoned that if Taiwan couldn’t hold its currency steady, despite having more than $80 billion in hard-currency reserves, then Hong Kong probably couldn’t maintain the long-standing system by which it rigidly links the value of its currency to the U.S. dollar. Hong Kong stocks sank by 23 percent on the first four trading days after Taipei’s move, and markets from New York to Sydney tumbled on the fear that a successful assault on the Hong Kong dollar would shatter a pillar of confidence in one of the world’s most stable financial enclaves.

  But as it turned out, the country leading the downturn in Asia was not Hong Kong—which steadfastly held the value of its currency by raising interest rates to extremely high levels—but Korea. Korean officials well remember when they began to realize their economy was facing a crisis of potentially epochal proportions: It was on November 4, a day after they had increased the ceiling for foreign ownership of stock in publicly traded companies, from 23 to 26 percent. “That kind of market opening used to draw about $1 billion or so of foreign money,” recalled Lee, the former central bank governor. “But although some foreign money did come into the Seoul stock market at first, it was soon withdrawn.” The won, which had been hovering at 915 to the dollar before the Taiwanese move, sank to the 1,000-per-dollar level by November 10.

  Just that fast, the Electronic Herd was galloping away from everything Korean. Many of the foreign banks that had extended loans to Korean borrowers were canceling them and demanding repayment as they came due, departing from their previous practice of routinely rolling the loans over. The decline in the won unnerved them, since it was increasing the burden on Korean debtors to repay the dollars they owed. Another factor was Jitteriness about the nation’s banking system. In any case, it didn’t take much for the foreign bankers to conclude that they ought to take their money and run. As one IMF official recalled:I was being called by a lot of banks in October and November, and it was amazing how little they knew about Korea. They’d ask, “Has Korea ever defaulted?” Well, the answer is no. They’d ask, “How recent is Korea’s miracle? Isn’t it all driven by foreign capital flows?” Well, it’s not. I remember one indignant guy in New York saying, “We’re a responsible bank; we cannot roll over our claims on a nontransparent country.” And I thought, “Well, you certainly seem to have been able to lend to them!” In a panic situation, once something becomes an issue, no bank wants to be left out on a limb.

  Amid rampant speculation in mid-November that Korea would be forced to seek IMF help, a plan was hatched to bring Michel Camdessus to Seoul for secret consultations with top Korean officials. The scheme to keep the press from learning about the visit by the IMF managing director was based on a simple proposition, recalled Kim Ki Hwan, who was then Korea’s ambassador-at-large for economic affairs: “Most Koreans cannot tell one Western face from another.”

  Camdessus arrived at Seoul’s Kimpo Airport on November 16 in the manner of a typical traveler, with no official welcoming party, on the assumption that nobody would pay attention. His Korean hosts used an ordinary commercial car, picked up Camdessus (and Hubert Neiss, who was accompanying him) near the airport taxi stand, and drove them to the Intercontinental Hotel, where they registered under Korean names.

  The Koreans were taking this step with dread. In the hopes of avoiding a Fund program, Finance Minister Kang had sent one of his top deputies to Tokyo on November 11 to ask the Japanese Finance Ministry to grant a bilateral loan and to pressure Japanese banks to cease cutting their credit lines to Korean banks. But the deputy returned empty-handed. So two days later, Kang had gone to the Blue House, Seoul’s presidential mansion, along with the central bank’s Lee Kyung Shik and other top economic policymakers, to break the news to President Kim Young Sam that Korea would almost certainly have to request IMF support. For the president, whose five-year term was nearing its end, the pill was especially bitter to swallow. The year before, he had led his country during its triumphant entry into the ranks of advanced economies belonging to the Organization for Economic Cooperation and Development (OECD). Now he would exit amid unprecedented national humiliation, and his party’s candidate to succeed him, Lee Hoi Chang, was sure to suffer in the election, which was a little more than a month away.

  As mortifying as it was to approach the Fund with hat in hand, the one scenario Seoul feared even more was default. The problem wasn’t the government’s own debt—unlike the Latin Americans in the 1980s, the Korean government had borrowed little from abroad. The debts were private (as in Thailand and Indonesia) and were owed almost entirely by banks. But a default by a major Korean bank would surely trigger a run on the system, and in any case the Ministry of Finance and Economy had announced in August that it would back the foreign obligations of the country’s banks (a move aimed at forestalling contagion). Byeon Yang Ho, a senior official of the Ministry of Finance and Economy, recalled that the Korean government never considered a default a viable alternative because of the concern that foreign banks would respond by refusing to grant even routine trade credits in the future: “We have to import most energy and raw materials—that’s the fundamental structure of the Korean economy,” Byeon said. “Once we default, there would be tremendous difficulty obtaining energy and raw materials. The whole economy would halt.” Lee Kyung Shik emphatically agreed: “I always thought default would be the worst thing. If we couldn’t borrow [foreign] money, the economy would be crushed, for maybe two or three years.”

  So with the realization that Korea’s back was to the wall, Kang and Lee met with Camdessus and Neiss on November 16 at the Intercontinental. They couldn’t go to the hotel’s restaurant without possibly blowing Camdessus’s cover, Kang recalled; instead, they ordered “room service and a few glasses of Scotch.”

  The two sides reached agreement that Korea would need an IMF-LED package of loans totaling about $30 billion. On the subject of the conditions the Fund would demand, the Korean attendees said they were struck, in retrospect, that Camdessus barely raised issues he would harp on a couple of weeks later concerning the need for a root-and-branch transformation of the Korean economic system. The IMF chief did not speak of bringing the chaebol to heel or of terminating the incestuous ties between the conglomerates and their bankers. Instead, he praised the financial reform legislation that Kang was vigorously promoting in the Korean National Assembly.

  Even so, Camdessus probed for hidden time bombs in Korea’s financial situation, fearing that some ugly surprises might be lurking in the data as they had in the Thai case. One of his first questions was about the Bank of Korea’s hard-currency reserves, which the central bank had publicly put at $30.5 billion at the end of the previous month. The reply was that there was enough to last until at least the end of the year, though Korea might run out in early 1998. Pressing further, Camdessus asked whether the Korean central bank had engaged in the sort of swap and forward market transactions that the Bank of Thailand had conducted; the reply was yes, but only about $6 billion worth. Camdessus was relieved. “He said that when [the IMF negotiated its program with Thailand], the Thais had almost no reserves. But Korea has at least one month and a half to go,” Kang recalled.

  In fact, Korea was in much deeper trouble than its official figures indicated, and the true shallowness of its reserves would come as a shock to the mission led by Neiss over the Thanksgiving weekend. Camdessus didn’t ask—and the Koreans didn’t mention—where the reserves were deposited, or whether they were immediately accessible in a crisis. That would prove to be quite an oversight, because much of the central bank’s hard currency had been deposited in the overseas branches and affiliates of Korean banks, where it was already being used to meet debts falling due, and it couldn’t be withdrawn quickly without wrecking the banking system.

  Another critical piece of missing information concerned the
full extent of Korea Inc.’s foreign obligations. Official Korean figures indicated that Korean firms had about $65 billion in payments falling due over the coming year. But as the Neiss mission would learn, the figure was much greater; the overseas affiliates of Korean banks and companies owed an additional $50 billion in debts.

  The upshot was that until the last minute, the IMF was unaware of how vulnerable a seemingly prosperous country like Korea could be to a panic. To a large extent, the fault lay with the Fund’s obliviousness to some of the obscure sources of potential instability that have arisen in an increasingly globalized financial system.

  In calculating Korea’s foreign indebtedness, the Fund’s Article IV mission that visited Seoul earlier that autumn had used the standard measure, which included only the debt owed to foreigners by companies, institutions, and people resident inside Korea. It did not count the debt owed by Korean entities based overseas such as, say, the New York branch of Korea First Bank. But in a crisis, when foreign creditors start calling in their loans to anyone or anything Korean, all those debts suddenly require Koreans to fork over dollars to foreigners, and the demands on the central bank’s reserves can become overwhelming. “We’d been asking the wrong questions before,” admitted a member of the mission team. “We didn’t worry about the foreign debt of nonresident Korean entities. But in fact, these entities were also borrowing overseas, and ultimately those debts came home to the Bank of Korea.”

  The Koreans also apparently failed to realize the danger posed by the debt. In fact, Korean officials were so confused about the issue that they produced wildly disparate figures during the course of the crisis. “We were asking for a rescue. There was no intention to hide anything,” said Lee Kyung Shik of the Bank of Korea. “Nobody cares what the short-term debt is, as long as the situation is stable. It could always be rolled over, so we didn’t care about it. But suddenly, when the reserves fell, the short-term debt became really critical. I was surprised, and they [IMF officials] were surprised, too.”

  The clandestine hotel meeting of November 16 ended with agreement on a plan: Korea’s intention to seek IMF support would be announced on November 18, the day after the scheduled vote on the financial reform bills. Camdessus slipped out of Seoul on the morning of the seventeenth, still unnoticed by the press. But the plan hit a snag when the National Assembly voted down the bills—and Kang was abruptly dismissed as deputy prime minister and minister of finance and economy on November 19.

  With the won sinking further by the day, President Kim immediately replaced Kang with Lim Chang Yuel, his trade minister, who looked as if he would prove much more troublesome for the IMF than the reform-minded Kang. A former Finance Ministry bureaucrat, the nationalistic Lim was no shrinking violet. In some of his first public remarks as finance minister, Lim suggested that Korea would try to survive without IMF aid, and he pressed for direct loans from the United States and Japan, asserting bluntly: “It is in their national interests to help.... If the Korean currency depreciates beyond its value, it will seriously affect the Japanese economy.” Washington and Tokyo rejected the request from Lim, whose haughty words helped send the won plunging 10 percent, to 1,139 per dollar on November 20.

  On that tumultuous day, the IMF’s Stan Fischer arrived in Seoul, having coincidentally arranged to visit there during a swing through Asia. The Korean press caught wind of his presence and surrounded his hotel room, congregating to such an extent that he complained over the phone he was literally trapped inside.

  Fischer finally waded through the throng of reporters and photographers to meet Lim over dinner. Lim seemed to be reconciling himself to the necessity of an IMF program, after having learned that the country’s reserves were fast depleting. But Lim’s attitude bespoke the state of denial then afflicting the Korean body politic. He asked how much growth the IMF would permit Korea to have, and Fischer replied that the Fund didn’t have the power to control such matters. “The Korean people,” Lim retorted, “will not accept growth of less than five percent”—a remark that prompted Fischer to assert he suspected Korea’s growth in 1998 would be more like zero. (Even Fischer was evidently not contemplating the minus 7 percent that would actually materialize.)

  The next day, the two men held another brief meeting, and within hours Lim finally made it official: Korea would seek an IMF loan. As for Fischer, he rushed to the airport to catch a flight for London and called Neiss from the car to order the dispatch of the Fund mission. Photographers dogged him all the way to his plane. The headlines in the following day’s Korean newspapers—“National Bankruptcy” and “Humiliating International Trusteeship”—bespoke the nation’s trauma over the turn developments had taken. In an editorial, the Dong-Ah Ilbo, a leading daily, lamented: “This is tantamount to losing our economic sovereignty.”

  Four days later, on the day before Thanksgiving, Charles Siegman, senior associate director of the Federal Reserve Board’s Division of International Finance, was sitting at his desk a few minutes before 9 A.M. when a call came from Lee Keun Yung, the head of the Bank of Korea’s Washington office. Lee wanted to see Siegman right away. Fifteen minutes later, an apologetic Lee was in Siegman’s office. He was seeking the Fed’s help, he said, because the Bank of Korea’s usable hard-currency reserves were very low, with so much draining out of the country daily that default might be only days away. Siegman was taken aback: Earlier in the week, he and Fed chairman Alan Greenspan had met Lee for breakfast, together with Lee Kyung Shik, and the figures available then had seemed less dire. (Lee would later insist that the figures he gave Siegman that day were consistent with the ones provided at the breakfast; there may have been a misunderstanding.) Siegman said he would have to see Greenspan immediately and promised to get back to Lee.

  The information, of course, was essentially the same as what Neiss would learn at the Korean central bank’s Seoul headquarters that same day. But now it was being provided to the U.S. government, and it would soon galvanize Washington’s top echelons—not only the economic bigwigs but the national security team at the White House and the State and Defense Departments as well. This was Korea, after all. Its economy was of far greater potential importance to the global financial system than Thailand’s or Indonesia’s, and it stood at one of the last remaining flashpoints of the Cold War. Within its borders were 37,000 U.S. troops, poised to help fend off any incursion from the erratic and fanatical regime to the north and providing a reassuring symbol of America’s commitment to maintaining stability in Asia.

  Upon hearing the news, Greenspan called Treasury Secretary Bob Rubin and, together with Siegman, headed to the Treasury for a meeting over lunch in Rubin’s private dining room. Deputy Secretary Larry Summers was out of town that day, and participated only briefly by speakerphone, but the rest of the Treasury’s international brain trust quickly gathered. Heading the list was David Lipton, the undersecretary for international affairs, a quiet, intense Harvard Ph.D. who had worked eight years at the IMF. Also in attendance were Tim Geithner, the assistant secretary for international affairs; Caroline Atkinson, deputy assistant secretary for international monetary and financial policy; and Daniel Zelikow, deputy assistant secretary for Asia, the Americas, and Africa.

  The mood at the meeting was a combination of shock, worry, and anger. Why, the participants wondered, were the Koreans conveying the information about their reserves when it was almost too late? Was Seoul playing some sort of trick, to panic the United States into making an emergency loan?

  Presiding over the discussion was Rubin, who mostly listened, asked questions, and scribbled notes on a yellow legal pad, as was his habit on such occasions. Famously deliberative, the fifty-nine-year-old Treasury secretary had made a fortune on Wall Street of well over $100 million by examining all the facets of prospective investments and basing his decisions on carefully calibrated Judgments about whether the potential rewards outweighed the risks. At the Treasury, he applied the same cold-blooded logic to the making of economic policy.

/>   Trained as a lawyer like his father, Rubin had spent two years at a top-drawer Manhattan law firm, but he found the work boring and Joined Goldman, Sachs & Co. in 1966. There he worked closely with Goldman’s chairman Gus Levy, a cigar-chomping, hard-drinking Wall Street legend whose “technique for management was yelling,” as Rubin once put it. Rubin made partner in Just four years, and he was one of Levy’s favorites, despite having an almost diametrically opposite personality and taste in consumables. (Rubin’s lunches of carrot sticks, salad, and mineral water would put a fashion model’s diet to shame.) Seemingly impervious to the tumult around him in the Goldman trading room, Rubin’s sunken eyes and angular features were the picture of studied calm almost regardless of the pressures he was under. And he was under plenty.

  Rubin made his name in “risk arbitrage,” which involves buying the stocks of companies being targeted for takeovers or mergers. Suppose, for example, Company A makes a $50-a-share bid to buy Company B, whose shares have been trading at $35, and Company B’s shares rise to $48 on the news. Tidy profits can be earned by buying up massive amounts of Company B’s stock at around $48 and reaping a small gain on each share when the deal is consummated. On the other hand, if the deal falls apart, a large stake in Company B would generate ruinous losses, since the stock would presumably fall back to its original price of $35. Thus each investment decision involves a fair amount of research—what, for example, do the antitrust lawyers say?—plus a bit of mathematics: Given all the possible factors that could derail the deal, how high are the chances it will go through at $50 a share or higher, and how high are the chances that Company B won’t be bought at all? From these calculations, do the probable profits appear to outweigh the probable losses?