Financial and Corporate Restructuring Lessons from Korea to Latin America and the Caribbean

Paper prepared for

Inter-American Development Bank

Yoon-Shik Park Professor of International Finance

George Washington University Washington, D.C.

April 16, 2003

Executive Summary: Potential Lessons for Latin America and the Caribbean The Korean financial crisis of 1997-98 has taught us some valuable lessons that might prove useful for Latin America and the Caribbean in the increasingly integrated world. First, despite the fact that the flows of capital to Asia were originally touted as an example of the benefits of free international capital markets in directing resources to the most productive uses, yet in the aftermath of the crisis it was shown that free international capital flows would not necessarily lead to the most productive use of financial resources but instead to highly speculative and excessive investments in real estate and other massive projects of doubtful economic and financial value. Total returns on capital investments in Asia have in fact been lower than in most other regions of the world throughout the early and mid 1990s.1 Second, tight fiscal and monetary policies proved counter-productive in dealing with a modern financial crisis, triggered in part by massive and panicky capital outflows, in the current integrated and liberalized world economy. Rather than reversing capital flights, they ended up devastating otherwise viable businesses and sharply increasing unemployment. With the firm support of the U.S. government, the IMF initially forced crisis-stricken Asian countries such as Thailand and Korea to adopt tight fiscal and monetary policies, which exacerbated the crisis by further weakening the already fragile banking system by massive corporate bankruptcies and skyrocketing bad debts. Many economists, including those at the World Bank, have rightly criticized such policy approach by the IMF as initially worsening Asia’s problems rather than helping to solve them. Third, too hasty financial liberalization and capital market opening might be counter-productive, unless they are accompanied by a sound domestic financial system and a strong regulatory framework. Therefore, sequencing is the key to a successful liberalization regime. Before adopting a full-fledged policy of free capital flows, governments should first ensure the establishment of a sound domestic banking system along with an adequate regulatory and supervisory framework. Fourth, it has become clear that international investors have a short memory span. Even though the U.S. government and the IMF, along with international banks, warned developing countries of dire consequences if they rescheduled their foreign debts or otherwise treated foreign lenders badly, foreign bankers and investors would go back to those same countries as soon as they could sense an opportunity to make money. After the severe 1994-95 financial crisis, Mexico was able to tap international capital markets successfully in 1996. Barely a year after Malaysia was harshly criticized by international bankers and the Washington policy establishment for its unilateral currency and capital controls, the country was welcomed back in 1999 to international capital markets to issue as much as $1 billion in new bonds. One may conclude, therefore, that governments should not worry too much about all the scare talks of irreparable damages and permanent blacklisting of a country by the international banking community. Governments should do what is needed in their self-interest first. When their economies become strong again,

11 J. A. Kregel, “Derivatives and Global Capital Flows: Applications to Asia,” Working Paper No. 246, The Jerome Levy Economics Institute of Bard College, August 1998.

international investors are likely to stream back despite any earlier displeasure shown by the international financial establishment. Fifth, a future financial crisis should be handled in such a way that private international lenders and investors also carry their fair share of responsibility. So far, private international lenders and investors have generally been “bailed out” at the taxpayers’ expense through the use of the funds provided by the IMF and various multilateral development banks. Such a practice has two problems. First, it is patently unfair that the general public should shoulder all the responsibility to clean up the economic debris of a financial crisis that was in part caused by the reckless and imprudent practices of international lenders and investors seeking to maximize their profits in various emerging markets. Higher expected returns in these emerging markets should also carry higher risks for the same investors and lenders, rather than always being bailed out with the public funds. Second, even more important than the issue of fairness is the issue of moral hazard. The way the recent financial crises from Mexico to Asia have been handled under the aegis of the U.S. government and the IMF through the so-called Washington consensus has encouraged the very reckless behaviors of international lenders and investors to plant the seeds for even bigger future financial crises. It is time, therefore, to break this vicious cycle by also “bailing in” the private international lenders and investors in future financial crises.

Finally, it is important for a country or a region to discard hubris and to understand that, no matter how successful their economy might have been in the past, a sudden economic crisis can be triggered by any number of causes in this integrated world economy. For that matter, a country should not be contented or complacent when the Washington policy establishment and the international investment community heap praises on it. Before the 1997-98 crisis, those Asian countries that subsequently suffered their worst financial crises in their post-World War II history had been praised profusely for their impressive economic record by the IMF, the U.S. government and the international financial community. Barely two months before the crisis hit Korea, for example, the country was singled out for special praises as being different from other South Asian countries by senior IMF officials and others during the 1997 IMF-World Bank annual meetings held in Hong Kong. International credit rating agencies have done no better in this regard. In October 1997, Korea’s credit rating was double-A minus (AA-) but barely two months later in December 1997, its credit rating was downgraded by ten notches to single-B plus (B+). Throughout the world’s financial crises in fact, the international financial establishment and officialdom have proven to be equally gullible as your next-door real estate speculators in their blindness to an impending doom. The only big difference between the two is that the former can often walk away with only a slight dent to their reputation, while the latter usually suffer far more severely in financial terms. One explanation for the failure to predict the Korean crisis is that previous crises in the Latin American region had largely been caused by such macroeconomic problems as fiscal or balance of payments crises, and analysts looking for similar weaknesses in Korea found few of the signs of a classic external crisis. In Korea, economic growth was relatively high; inflation remained low; the real exchange rate was not thought to be overvalued; the current account deficit was within a sustainable range; and the government fiscal position was strong. Moreover, the record of prudent and flexibly applied macroeconomic policies suggested that Korean economic 2

policies would respond appropriately to a large shock. In the event, however, the Korean crisis was the result of excessive regulation and mismanagement of companies and banks, not an undisciplined government or poor macroeconomic fundamentals. From a broader perspective, Korea may also have been a victim of its own success. Although many observers were aware of the growing problems of the highly leveraged corporate sector and a weakened financial system, the fact that these weaknesses had existed for so long while Korea continued to grow rapidly may have created a sense of complacency and confidence that Korea would be immune to a crisis. Korea’s model of development worked remarkably well over a sustained period of time before the crisis. However, as Korea advanced and became more integrated with the global economy, the government- and chaebol-led system that had functioned so well during periods of rapid growth proved ill-equipped to deal with new types of shocks to what had become a more developed economy.

Financial and Corporate Restructuring Lessons from Korea to Latin America and the Caribbean

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I. Introduction Korea has experienced a sharp, V-shaped economic recovery since the 1997-98 financial crisis. From a level of –6.7% real GDP growth rate in 1998, Korea recorded an increase in GDP of 10.9% in 1999 and 9.3% in 2000. The unemployment rate declined from 6.8% in 1998 to 2.8% by the end of 2002, and Korea’s foreign exchange reserves increased from less than $10 billion in December 1997 to $121 billion by the end of 2002, the fourth highest in the world after Japan, China and Taiwan. This remarkable turnaround is forcing a reassessment of the Korean crisis and generating questions about the applicability of the Korean lessons to other regions of the world such as Latin America and the Caribbean. In order to answer these questions, one has to understand first the root causes of the Asian financial crisis in general and the Korean crisis in particular. There have been a number of articles and papers in the West that have attempted to decipher the origin of the Asian financial crisis. In general, there are two schools of thought on the origin of the Asian financial crisis. One argues that the crisis was essentially a panic, in which foreign investors rushed for the exits because everybody else was rushing for the exits. The other argues that those Asian countries hardest hit by the crisis had fundamental economic structural vulnerabilities, which would be eventually exposed someday no matter what. Both arguments have a certain justification, even though there can be a dispute about their relative importance. The Asian economic and financial crisis was caused by many factors, some domestic and others external. Domestically, one has to mention first of all the excessive government regulation of their economy that has led to the inefficiency and high costs of doing business, thus making its economy less competitive, especially since the early 1990s. In Korea, for example, a study shows that it takes on average 925 days and 44 government permits and licenses to build a factory, with receiving of each permit and license usually requiring payment of bribes. The so-called "four highs" (high land/factory site cost, high transport cost, high wages, and high interest rates) as compared to those of Korea's major competitor countries had been due mainly to the excessive government regulation that choked the economy through burdensome and inflexible rules and procedures. Second, the inefficient and backward Asian banking and financial system has misallocated the scarce financial resources, favoring large and politically well-connected firms at the expense of small and medium-sized companies. Credit allocation was manipulated through the symbiotic collusion among influential politicians, top bureaucrats, and well-connected businessmen, with bribery providing the glue in this iron triangle. Some would defend this Asian way of doing business as part of “Asian values.” Asian bankers were cavalier in their lending decisions, which were based more on political connections than on rational credit appraisals. Excessive reliance on the collaterals for lending decision also stunted the credit evaluation capability of local Asian bankers. In Korea, one result of excessive reliance on collaterals was that there was a plethora of bank clerks but not many competent loan officers, who could have controlled excessive lending practices of Korean banks toward chaebol firms which later went bankrupt due to the liquidity crisis and cash flow problems exposed during the Korean financial crisis. 4

Third, corporate governance in Asia was stuck at a primitive stage. The minority shareholders had almost no practical ways to inspect the books of their own companies and they could not easily sue the company chief executives for their willful mismanagement and gross negligence. The board of directors was composed entirely of internal directors whose executive careers were at the mercy of company chairmen, thus unable to exercise the board's proper supervisory function of performance evaluation and management audit. In Korea, for example, cross shareholding among chaebol affiliated companies and credit guarantees among chaebol companies served to enable chaebol chairmen to exercise absolute management control. As a result, mis- and over-investments have been frequent without thorough investment appraisals and they were financed largely through debt rather than equity funding. Returns on investments (ROIs) for Korean companies have been very low due to such over- and mis-investments. It has been reported that, in 1996, even though the Korean economy was rather robust with the real GDP growth rate of 7.1 percent and the combined reported profits of the companies listed on the Korea Stock Exchange were over $3 billion, their combined economic value added (EVA) turned out to be negative $3.2 billion. In other words, Korean companies failed to generate the true profits out of their investment capital, thus wasting valuable financial resources of the country. Poor accounting standards have also led to unreliable financial statements, turning off many potential long-term foreign direct investors away from Asia due to the lack of transparency. Fourth, the corporate sector was highly exposed to the risk of default due to its heavy reliance on debt financing. For example, the average debt to equity ratio of top thirty largest chaebol companies in Korea was 5 times in 1997, compared to 1 or 1.5 times for most U.S. companies. High debt-equity ratios of many Asian companies and their continued demand for debt financing have been the major factor behind high interest rates as well as low profitability. Such a heavy burden of financial cost has also made these firms extremely vulnerable to cyclical downturns and changes in financial conditions. Heavy reliance by many Asian firms on short-term external debt denominated in foreign currencies can be attributed to not only the cheaper financing cost of short-term capital but also their limited (or denied) access to the international long-term capital market due to unhealthy balance sheets.

Fifth, financial supervision and prudential regulation were too lax to prevent reckless external borrowing by domestic financial institutions. Particularly, merchant banks in Korea and finance companies in Thailand invested in risky foreign assets, including Indonesian and Russian junk bonds, funded by short-term foreign bank loans. Such risky asset management should have been diagnosed and corrected, if there had been in existence an appropriate regulatory system. Sixth, the rigid labor policy has made it almost impossible for many Asian companies to lay off surplus workers, again defended as “Asian values.” Mergers and acquisition could not be used effectively to consolidate businesses due to inflexible labor laws and discouraged foreign direct investments. Finally, exchange rates in Thailand, Korea and Indonesia were not flexible, leaning against the strong market pressure for the currency depreciation resulting from the swollen current account deficits. Their currencies, therefore, ended up clearly over-valued by early 1997. Externally, the 1994 devaluation of the Chinese yuan by almost 40 percent and the steep 5

depreciation of the Japanese yen from the high of 80 yen per dollar in 1995 to 125 yen per dollar in 1997 worsened sharply the terms of trade for many Asian countries, whose currencies were tied rather closely to the U.S. dollar. Their exports were squeezed between the low-skilled Chinese exports and the high-quality, high-tech Japanese exports. As a result of deteriorating terms of trade and inflexible foreign exchange rate policies, the current account deficits jumped sharply, reaching 8 percent of GDP in Thailand and 5 percent in Korea in 1996. Furthermore, partly in response to rising current account deficits the abrupt reversal of external capital flows first triggered and then exacerbated the Asian financial crisis. A flood of international capital poured into Asian emerging markets until 1996 in search of lucrative investment opportunities opened up by premature and accelerated external financial liberalization in these countries during the early and mid 1990s, including $93 billion inflows in 1996 alone into just five Asian countries: Indonesia, Malaysia, the Philippines, Korea and Thailand. Then there was a net outflow of $12 billion from those same five countries in 1997. This sudden capital flow reversal in the magnitude of $105 billion over a two-year period was most evident in the short-term bank loans. Contagion among Asian countries also contributed to accelerating the financial crisis by scaring international investors into a panic. While structurally handicapped economies or policy mistakes by governments might have been tolerated somewhat in the past by the international financial markets, now the close international integration of financial markets penalizes much more harshly and promptly these economies or policy errors. The recent trend towards economic liberalization and financial market integration, while desirable in principle, has been too rapid for many Asian countries which have not developed the proper financial infrastructure of their own, such as a sound domestic banking system and a strong financial supervisory framework. II. Effectiveness of the IMF Policy Measures to Cope with the Asian Crisis The key ingredients of the IMF program to deal with the Asian financial crisis were a tight macroeconomic policy and structural adjustment. High interest rates and tight monetary policies, mandated in the IMF program, were claimed to be necessary or inevitable at least in the short run for the stabilization of the exchange rate. High interest rates were supposed to help not only stabilize the exchange rate by discouraging capital outflows (and equally, encouraging capital inflows) but also facilitate much needed corporate sector restructuring. Nevertheless, this textbook prescription needs to be reevaluated in light of the financial panic situation when high interest rates were not effective in reversing massive capital outflows from Asia. Given the heavy reliance on corporate debt on the other hand, high interest rates mandated by the IMF imposed high financial costs on firms, and hence, significantly increased the risk of corporate bankruptcies. Additional bankruptcies and subsequent increase in non-performing loans on the books of the banking sector further discouraged capital inflows, offsetting any possible positive effects on capital inflows of high interest rate differentials between home and abroad. The IMF adjustment program based on sharply increasing interest rates for the purpose of stabilizing a weakening currency instead triggers a vicious cycle in which higher interest rates cause more bad debts in the banking system which discourage capital inflows and encourage capital

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outflows, thereby requiring even higher interest rates, and so on.

The main components of the IMF conditionality for the affected Asian countries were born originally in the 1980s when the IMF was called upon to deal with the LDC debt crisis that was first triggered by Mexico in 1982 and then spread to other developing countries in Latin America, Africa and the Eastern Europe. The common economic characteristics of those heavily indebted LDCs in the 1980s were large fiscal deficits, over-valued currencies, high inflation rates in the double or even triple digits, and heavy government subsidies to bloated public sectors and parastatals. It was natural, therefore, for the IMF to adopt its loan conditionality primarily focused upon the aggregate demand management. However, the IMF demonstrated its tendency to continue this policy inertia for the Asian countries mired in the 1997 economic crisis as well. However, such IMF conditionality was ill suited to the Asian crisis, where the countries affected had quite different macro-economic parameters than those LDCs assisted by the IMF in the 1980s. Inflation was not a serious problem for the affected Asian countries and their budget deficits were either negligible or non-existent unlike many Latin American countries in the 1980s. The IMF should in this case, therefore, have refrained from its obsession with the aggregate demand management through tight fiscal and monetary policies. Instead, it should have focused upon economic structural reforms such as economic liberalization, deregulation, privatization of state enterprises, down-sizing of government agencies, financial sector reforms, strengthening of prudential supervisory infrastructure, promotion of competitive business practices through stringent monitoring of insider trading and cross-guarantee of affiliates’ debts, ensuring business transparency with the adoption of international accounting standards, modernization of corporate governance, labor market flexibility, etc. III. The Financial Sector Reform Since the beginning of the financial crisis, the Korean government has realized that the country’s financial sector is in need of fundamental reform and restructuring. The objective of financial sector restructuring is therefore to develop the Korean financial sector into a strategic industry by enhancing its overall competitiveness through conforming to international best practices, following transparent principles of accountability, and strengthening and deepening the institutional structure of the financial sector. In 1998, the Korean financial sector underwent the most comprehensive consolidation affecting the entire range of financial institutions. An unprecedented number of financial institutions have had their licenses revoked or operations suspended. In total, 96 banks and non-bank financial institutions were directly affected in the consolidation through mergers and acquisitions (M&As), purchase and assumptions (P&As), and other measures. In order to ensure the financial soundness of the acquiring banks, non-performing assets of the liquidated banks classified as substandard or lower were excluded in the transactions, while all the liabilities were transferred to the acquiring banks, excluding the liquidated banks’ provisioning funds for severance and retirement payments. Any shortfalls in the net worth of the 7

liquidated banks were covered by the Korea Deposit Insurance Corporation (KDIC). The Korea Asset Management Corporation (KAMCO) and KDIC were made responsible for the disposal of non-performing loans (NPLs) of the liquidated banks, and the acquiring banks can exercise a put-back option within a set time period after P&A transactions by requesting KAMCO to purchase their acquired assets if any of them are later found to be non-performing. The government has applied basically the same restructuring principles to the non-bank financial institutions (NBFIs) as in the case of commercial banks. The Financial Supervisory Commission (FSC) first made a thorough review of the financial soundness of NBFIs and their rehabilitation plans. Those NBFIs whose rehabilitation plans showed negligible hope of an eventual recovery were closed down, merged or their operations suspended. Among the original 30 merchant banks in operation at the end of 1997, 16 of them have had their licenses revoked and are currently undergoing resolution procedures. The remaining 14 merchant banks are monitored for the implementation of rehabilitation plans and the achievement of the 8% BIS minimum capital adequacy ratio. Among 34 securities companies, two of them have had their licenses revoked and the operations of 4 securities companies have been suspended. The FSC also decided to liquidate the 4 previously suspended insurance companies, whose assets and liabilities were transferred to healthy companies. The remaining 16 insurance companies that are subject to management improvement measures are closely monitored for their progress. Two surety insurance companies decided to merge for the sake of financial rehabilitation. Among 26 leasing companies, the controlling shareholders of 10 have decided to dissolve their companies, which are currently either undergoing liquidation on their own accord or in the process of transferring their assets and liabilities to a bridge leasing company. The remaining leasing companies are closely monitored by FSC on implementation of their rehabilitation plans. Investment trust companies, mutual savings and finance companies, and credit unions have also gone through a similar process of consolidation through mergers or liquidation as well as other rehabilitation procedures. IV. Modernization of the Financial Supervisory Framework Traditionally, the financial sector in Korea used to be closely regulated and monitored by the government. Licensing of new institutions as well as development of new financial products or services was subject to the micro management of financial regulatory agencies, which were dispersed among the Ministry of Finance and the Bank of Korea. Informal and close relationship between the regulators and the regulated financial institutions was maintained also through the practice of the so-called “parachute appointments” of the retired ex-regulators in top executive positions. This practice, known as “Amakudari” or decent from heaven in Japan, was especially pervasive and entrenched among NBFIs and their trade associations. Furthermore, the supervision of financial institutions was divided among the Ministry of Finance and Economy (MOFE) and the Bank of Korea (BOK). The Office of Bank Supervision of BOK regulated and supervised commercial banks, while MOFE exercised similar powers for NBFIs through its agencies such as the Securities Supervisory Board (securities houses), the Insurance 8

Supervisory Board (insurance companies), and the Non-bank Insurance Corporation (mutual savings and finance companies as well as merchant banks). The dichotomy of regulatory structure resulted in a lack of consistency in supervisory practices and inadequate coordination among regulatory bodies. While BOK through its Office of Bank Supervision was responsible for commercial bank supervision in general, MOFE was responsible for supervising trust business of commercial banks as well as for granting and revoking bank licenses. After the passage of a set of financial reform laws in December 1997, all financial regulatory and supervisory functions have now been unified under FSC, which has taken over the entire supervisory role for both commercial banks and NBFIs. After one year of preparation, the four financial regulatory agencies were formally consolidated into the Financial Supervisory Service (FSS) under the direction of FSC. The ultimate goal of FSC is to improve Korean financial supervision levels to meet international standards. In this endeavor, FSC has set up new paradigms through the conversion of supervision practices from direct regulatory methods to indirect ones, from the positive system to the negative system, from the application of abstract and subjective principles to transparent and objective principles, from organizational supervision to functional supervision, etc. In this sense, FSC tries to enhance its level of financial supervision to that of international best practices. For example, FSC has adopted the Prompt Corrective Action (PCA) system, defined as the step by step imposition of obligatory corrective measures by FSC on unsound financial institutions that fall below a certain level of capital adequacy. Authorized under the Act Concerning the Structural Improvement of the Financial Industry, the PCA system allows FSC to adopt the criteria for deciding whether financial institutions are sound through the use of capital adequacy standards. These standards are the BIS capital adequacy ratio for banks and merchant banking organizations, the operational net capital ratio for securities companies, and payment capacity insufficiency ratio for insurance companies. A three-step corrective measure, composed of management improvement recommendations, management improvement measures and finally management improvement orders, can be imposed on any unsound financial institutions according to the degree of their unsoundness. To enhance the accounting transparency of financial institutions, FSC has also adopted the mark-to-market accounting method, which values the assets, instead of at their historical acquisition costs, at their fair current market value at the valuation date, amends the book value, and recognizes the gains or losses from the difference. Up until now, financial institutions in Korea have not adopted the mark-to-market accounting for securities, even though it is in common use internationally. In addition, the accounting standards for public disclosure and the accounting standards for supervision, which had been integrated until now, will be separated and administered separately. Furthermore, FSC has increased the regular public disclosure items to the level as requested by the International Accounting Standards (IAS), to include, for example, off-balance sheet transactions such as derivatives, asset classification, special disclosure items such as those related to financial mishaps, the losing of a lawsuit of large sum, and others. Also, for the sake of internationalization, the titles of accounts, which have been only in Korean so far, will be written in both Korean and English. However, issues such as corporate governance of financial institutions, loan concentration, and consumer protection provisions have not been 9

taken care of up to now. The government has also strengthened loan classification standards and provisioning requirements to make them more conservative. In accordance with international standards, loans in arrears for three months or longer are now classified as substandard and below, and loans in arrears between one and three months are classified as precautionary loans. Table 1. Changes in the Loan Classification Standards

Period of Overdue Payment Old New 1 to 3 months Normal Precautionary 3 to 6 months Precautionary Substandard or Doubtful Over 6 months Substandard or Doubtful Substandard or Doubtful The government will facilitate the disposal of NPLs held by those financial institutions planning mergers or those whose rehabilitation plans have been approved by FSC. Actual purchases are carried out by KAMCO for all bad loans that fall into the category of substandard or below, whose interest payments are more than three months in arrears. Fiscal resources to address all these restructuring measures are to be mobilized largely by means of issuing public bonds. The Korea Asset Management Fund and the Korea Deposit Insurance Fund are the bond issuers, while the government will provide a guarantee on these bonds and will bear interest costs. V. Promotion of the Financial Market Development In the aftermath of the Asian financial crisis, many experts have observed that existence of robust financial markets in Asia would have encouraged international portfolio investors to invest in Asian capital market securities, which would have been a far more stable form of foreign capital flows than short-term bank loans. Furthermore, strong financial markets would have required Asian countries to enhance their financial and corporate transparency, because capital market financing necessitates more stringent financial disclosure than bank financing. In the past, Korea has relied too much on foreign commercial banks as the primary financial intermediation channel for foreign capital, while neglecting to develop a strong Korean capital market. Over-reliance on commercial banks in general has led to more short-term debt financing, both domestic and foreign, than long-term capital market funding. The especially high ratio of short-term debt to long-term debt is one of the main causes of unstable financial structure of many Korean firms. Promotion of the equity and fixed income securities markets, including both the bond and money markets, is an important new trend around the globe, as many countries have finally realized the importance of financial markets to their economy, in order to supplement their traditional reliance on the banking system alone. The financial market not only provides an alternative source of long-term funds for companies compared to the generally short- 10

term funding from commercial banks, but it also brings about many ancillary benefits such as greater financial transparency, deeper financial infrastructure, more effective monetary policy operations, more investment opportunities to savers, and promotion of many innovative financing techniques, as well as promoting more stable and longer-term foreign capital inflows. It is well recognized that the government can play an important role in promoting the development of an efficient and robust financial market. Broadly, the positive role of the government can be categorized into two areas. First, the government should adopt a proactive approach in market deregulation, financial liberalization, discontinuing the practice of setting issuance terms, lifting the reserve requirements on repos, removal of various taxes such as stamp duties and transfer and withholding taxes, adoption of strong and modernized bankruptcy and foreclosure laws, introduction of modern accounting and auditing standards, adoption of a free brokerage commissions system, etc. Second, along with the various market liberalization moves such as the above, the government should also develop a strong and modern market supervisory framework in order to ensure competition and fair market practices by controlling the potential abuses of the market by powerful commercial and investment banks and other influential market participants. It is also important to understand the demand side of the capital market, in addition to the supply side such as the issuers, market makers and market infrastructure. A healthy capital market can exist only when there is a well-developed body of investors. It would be critical to understand the identity of these investors, their incentives and requirements for capital market instruments, and the measures required to broaden the investor base. In this connection, it is important for Korea to promote the development of strong institutional investors such as pension funds, mutual funds and insurance companies. Furthermore, it is critical to understand the market best practices that have been developed in various advanced capital markets so far. Mindful of these requirements in strengthening the Korean financial market, the government has adopted many bold measures, such as elimination of the ceiling on foreign equity ownership as well as removing limitation on foreign investments in local bonds and short-term money market instruments. Aware of the importance of efficient and reliable credit rating services for a viable financial market, the government has opened the credit rating service market to foreign competition, and is promoting joint ventures between foreign and domestic credit rating agencies. Korea has also developed an institutional framework for mutual funds as a way to deepen the rank of institutional investors in the capital market. Private investors, both domestic and foreign, are now allowed to easily establish mutual funds in Korea. A new law, the Asset Securitization Act, was also enacted in October 1998 in order to introduce asset-backed securities, which was especially useful in disposing of NPLs. The original purpose of the law was to help the Korea Asset management Corporation (KAMCO), the Korean equivalent of the Resolution Trust Corporation in the United States, liquidate through collateralized loan obligations (CLOs) non-performing loans that were acquired from troubled banks. After the Daewoo crisis in 1999, however, it was the investment trust companies (ITCs) that heavily securitized non-performing bonds to meet their large redemption requirement. As a result, collateralized bond obligations (CBOs), whose underlying pools were mainly composed of low-quality bonds that the ITCs held, were issued in large volumes. 11

VI. Corporate Sector Reform in Korea For several decades until the 1997 financial crisis, the Korean economy was heavily influenced by the government’s export-oriented growth strategy. The government tightly controlled the banking system to channel scarce financial resources into the export and other key industries strategically selected and favored by the government. Business firms in these strategic industries, which mostly belonged to chaebols, were able to benefit handsomely from this symbiotic relationship with the government and were able to grow rapidly by investing heavily into those sectors favored by the government. In such a business environment, market share, assets size and revenue growth were the main focus of large Korean chaebol firms, while the cash flows, profitability and the mounting debt burden were systemically ignored. Chaebols were controlled by their founding family members, who exercised their control through the centralized office of planning and coordination, which, though without any legal base for its authority, still directed and coordinated such key operations as finance, personnel, and investments of a chaebol group’s entire affiliated firms, and which was directly answerable only to the office of the chaebol chairman. Even though the founding families directly owned far less than 50 percent of the outstanding shares of their companies listed on the stock exchange, they were able to exercise effective management control over the entire group companies through cross-shareholdings among the many affiliated firms, both listed and unlisted, within the chaebol group. For the top 30 chaebols, the Korea Fair Trade Commission data showed that in 1997 the percentage shareholdings of the founding families amounted to only 8.5 percent while the cross-shareholdings were 34.5 percent, providing a total shareholding of 43 percent under the direct control of the chairman’s office. The comparable number was 57.2 percent in 1983 and 43.4 percent in 1993.2 In addition to cross-shareholdings, chaebol firms benefited from inter-company loan guarantees in order to ensure their preferred credit access to both Korean and international financial institutions. In the meanwhile, the rights of minority shareholders were severely limited. They had difficulty in accessing corporate financial information and their voice was not effectively represented to the management due to the lack of credible legal protection. The degree of transparency of published financial statements by companies was rather low due to the poor disclosure requirements under the traditional Korean accounting standards. For example, this was confirmed by a comparison of Korean accounting practices and disclosure rules for a sample of eleven chaebol firms and large banks with relevant international accounting standards (IAS’s).3 The study indicated that there was no disclosure of such key financial information as the amount of related party lending and borrowing, the amount of foreign debt in the currency of repayment, foreign currency translation gains or losses, commitments for off-balance-sheet financing activities and others, as recommended by IAS’s. 2 Choi, Inchul, “Reform of the Corporate Structure in Korea” in National Strategy and Reform Agenda for the 21st Century, Samsung Economic Research Institute, Seoul, Korea, 1997. (Written in Korean)

123 Matiur Rahman, The Role of Accounting Disclosure in the East Asian Financial Crisis: Lessons Leaned? United Nations Conference on Trade and Development, 1998.

Until 1997, hostile mergers in Korea were almost unheard of due to the unduly cumbersome tender offer process, while the concentrated chaebol ownership structure further made it difficult for outsiders to take over a firm. For example, the law prohibited outsiders to accumulate more than 5 percent of the outstanding shares of a company without an advance filing with the Korea Securities Commission. If anyone wanted to purchase more than 20 percent of the outstanding shares, more than 50 percent of them had to be purchased through a public tender offer. Furthermore, hostile takeovers by foreigners required a prior approval by the target company’s board of directors, discouraging the emergence of M&A (mergers and acquisitions) activities as an incentive for managers to maximize shareholders’ interests to prevent a takeover. Institutional investors such as banks, insurance companies, investment trust companies and pension funds were allowed only to exercise neutral “shadow voting” except in the case of mergers and business transfers for the ostensible reason of avoiding an undue exercise of voting powers by outside financial institutions. A system of shadow voting requires institutional investors to cast their votes proportionate to other votes cast. Under this system, the institutional investors could not effectively raise their own voice to maximize their share value. Moreover, in many cases institutional investors themselves were affiliated with chaebols, reducing their incentives to monitor the management of the company in which they invested. The result was a lack of vigilant oversight and supervision by institutional investors as in the United States and other advanced countries. Internal monitoring and supervision of management by an independent board of directors was also not possible due to the fact that all the board members were the senior executives of the company itself, whose managerial careers were wholly dependent upon the chairman and CEO in a system of life-time employment. In most advanced industrialized countries such as the United States, boards of directors are a critical element in corporate governance, as they are the link between the outside stockholders and the internal corporate management. On the other hand, the Korean boards of directors, composed of only inside executives loyal to the owner/manager, did not function at all as an important internal monitoring mechanism. Due to the widespread practice of lifetime employment, the managerial labor market remained underdeveloped and this reality further weakened managers’ incentives to increase the shareholder value at the expense of the interests of the owner/manager. Since the outbreak of the financial crisis, the Korean business environment has changed drastically, forcing companies to change their management practices including corporate governance. Some of the important factors for the structural changes can be cited as follows. First, as the government has aggressively pursued a policy of economic globalization and liberalization following the advice of such international organizations as the IMF and the World Bank, Korean companies have been constantly forced to meet global standards in terms of business decision-making, financial practices and accounting standards. Second, operational risk for firms has increased significantly due to the complete opening of the domestic market and consequent sharpening of foreign competition, resulting in heightened volatility of both revenues and earnings. Third, restructuring of the banking and financial system pursuant to the BIS guidelines has meant that bank loans are no longer automatically available even to some of the 13

largest chaebol companies unless the latter can demonstrate credible cash flow projections to potential creditors. Fourth, the government-mandated corporate restructuring has forced chaebol companies to reduce their debt-to-equity (D/E) ratios below 200 percent and to cease cross-guarantee of credits to their affiliated companies and other internal self-dealing. Fifth, the voices of shareholders, including foreign equity investors, have become louder, forcing domestic companies to improve their management performance. With the drastic change in the business environment, there has been a great turmoil in the Korean corporate scene. During the first three years since the financial crisis, 17 out of 41 chaebols, which have been in and out of the list of the nation’s top 30 chaebols since 1997, have been placed under the “workout” program, court receivership, court mediation or “life support” loans from creditors. The second largest chaebol as of early 1999, the Daewoo Group, was put into the bankruptcy proceedings, along with many other chaebols. As a result of the government’s “big deal” (business swaps), the total number of affiliates of the nation’s top 30 chaebols decreased from 821 in 1997 to 584 in late 2000. The D/E ratio of Korean companies decreased from 396 percent at the end of 1997 to 193 percent by mid 2000. Even though the D/E ratio has declined significantly, the liquidity of Korean companies has not improved, and the relative interest expense burden for companies has not been reduced much either. This is because they have reduced their D/E ratios through the issuance of new stocks and revaluation of their assets rather than actually reducing the outstanding amount of their debt. As a result, manufacturing companies’ average ratio of interest expenses to sales revenues declined only modestly from 6.4 percent in 1997 to 5.1 percent by mid 2000 despite a deliberate low-interest policy pursued by the government, which is far higher than 2.0 percent in the United States and 0.9 percent in Japan.4 Another significant change has been in the area of corporate finance, in that the preferred method of capital raising has now shifted from bank loans to direct financing such as the issuance of new stocks and corporate bonds or commercial paper. In the aftermath of the financial crisis, the government has initiated a series of reforms to modernize business practices in Korea. First, as a means to strengthen the internal monitoring of companies, the role of the board of directors has been strengthened and its membership diversified by including for the first time outside board members in addition to the traditional inside members from the senior executive ranks. As a first step, all exchange-listed firms were required from 1998 to elect at least one outside director to promote effective monitoring of management. From 1999, this requirement was further strengthened by increasing the proportion of outside directors to at least 25 percent of the board members in order to monitor effectively any conflicts of interests between management and shareholders. For large companies with the total assets of at least Won 2 trillion as of June 2000, more than half of the board members are required to be filled by outside directors from 2001. Eighty-two out of 704 companies listed on the Korea Stock Exchange and eight out of 604 companies listed on KOSDAQ in 2000 were qualified for this category.5

4 Korea Economic Trends, Samsung Economic Research Institute, November 25, 2000, p. 15.

145 Chosun Ilbo (Chosun Daily), December 31, 2000.

In order to ensure their independence, outside directors are also to be not closely related to the major controlling shareholders or anyone affiliated with them, and the role and the power of the board has been broadened significantly to establish the board as the supreme authority for key management decisions impacting the interests of shareholders. Large listed companies are also required to establish an independent audit committee comprised of at least three board members, two thirds of whom must be outside directors. The chairman of the audit committee is required to be filled by an outside director. For the purpose of enhancing the independence of auditors, external auditors must be chosen from 1998 by an independent selection committee consisting of internal auditors, outside directors, large creditors and the two largest non-controlling shareholders. Table 2: Outside Directorship for Firms Listed on the Korea Stock Exchange 1998 1999 2000 Number of firms 736 701 704 Percentage of outside directors 11.4% 24.8% 32.3% Average number of outside directors 0.91 1.72 2.12 Source: Korea Stock Exchange. Since 1998, various steps have been taken to strengthen the rights of shareholders, including especially the minority shareholders. Specifically, the minimum shareholding requirements have been drastically reduced for exercising key shareholders’ rights such as the right to file derivative lawsuits against the company management for any losses caused by mismanagement, to request dismissal of directors and internal auditors, to review accounting books, or to call for a general shareholders’ meeting. Laws have been changed to allow institutional investors to exercise effectively their voting rights by abolishing the shadow voting system, and banks have been permitted since 1998 to cast votes for the shares in their trust accounts. Shareholder activism has also been increasing, with minority shareholders’ and foreign investment funds’ voices now being loudly heard. For example, minority shareholders have filed lawsuits demanding compensation for losses allegedly caused by mismanagement, such as one against the Korea First Bank. Annual shareholders’ meetings of Korean companies used to be typically a convention event where the management agenda were routinely approved. Following the 1998 reforms to strengthen minority shareholders’ rights, however, various civic groups representing minority shareholders such as the People’s Solidarity for Participatory Democracy (PSPD) have been vocal in their demand for greater managerial transparency and improved corporate governance structure. Civic groups have also called for minority shareholders’ right to recommend and elect their own outside directors as a means to protect their interests. In fact, the PSPD in cooperation with the Tiger Fund, a major U.S. investment fund and an active institutional investor in Korea, succeeded in the appointment of three outside directors at SK Telecom in 1998. Also in March 1999, Dacom (a major Korean telecommunication company) reached an agreement with its 15

employee stock ownership association and the PSPD that each of them would appoint one outside director to the board. Several steps have also been taken to improve external corporate governance mechanism. In an effort to promote the M&A market, the government has removed the pre-reporting requirements for the purchase of more than 5 percent of the outstanding shares of a company. At the same time, laws requiring mandatory tender offers were abolished and merger procedure has been simplified. The government has also lifted most regulations restricting share purchases by foreigners. In December 1997, the ceiling on foreign equity ownership was raised from 26 percent to 55 percent of the total outstanding shares of a company and then completely eliminated in May 1998. In addition, the earlier requirement that foreigners obtain a prior board approval for ownership of more than one-third of the shares outstanding was dropped. Consequently, foreign investors, especially institutional investors such as hedge funds, have entered the Korean stock market enthusiastically and by late 2000, about 30 percent of the total Korean shares were owned by foreign investors. In addition to active foreign portfolio investments in Korea, foreign direct investments have been equally robust, with foreign interests taking over leading domestic companies in petrochemicals, paper manufacturing, medicine, food and automobile components. As a result, the proportion of the sales revenues of Korean manufacturing companies whose controlling shareholders were foreigners increased from 5.5 percent in 1996 to 18.5 percent in 1999. VII. The New Combined Financial Statements for Korean Chaebols On August 1, 2000, Korea’s Financial Supervisory Service (FSS) released for the first time a report on the combined financial statements (CFSs) of sixteen Korean chaebols or conglomerates for the fiscal year 1999. Right after the financial crisis, there were strong demands for the reform of accounting and auditing practices in Korea in order to enhance financial transparency. Among others, both the IMF and the World Bank required the Korean government to upgrade accounting standards and disclosure rules to meet international practices. In response, the Korean government embarked upon the reform process in two specific areas: (1) revision of Korean financial accounting standards consistent with international best practices patterned after the International Accounting Standards and the U.S. Generally Accepted Accounting Principles (GAAP), and (2) establishment of accounting standards for combined financial statements. Like most countries, the Korean accounting standards have traditionally required firms that have subsidiaries to prepare consolidated financial statements to cover a parent-subsidiary relationship where a company owns more than 30% of the other company’s voting interest. Because of the unique chaebol ownership structure in Korea, however, several consolidated financial statements are issued within the same chaebol, while many affiliated companies of a chaebol with less than 30% voting interest were not included even though they are under the effective management control of the chaebol. In order to address this reporting gap unique to the Korean chaebol structure, the Korean Parliament passed a bill that requires CFSs for large chaebols for fiscal years starting from January 1, 1999. The objective of CFSs is to present each chaebol group’s balance sheet, income statement and cash flow statement as a whole under the assumption that

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chaebol-affiliated companies, regardless of their respective voting interests, constitute a single economic entity. According to the new law, the 30 largest chaebols designated by the Fair Trade Commission are required to issue the audited CFSs covering all domestic and foreign affiliates that are under the effective control of an individual owner and his/her relatives. In this way, all intragroup balances and intragroup transactions are eliminated in the preparation of CFSs. According to the CFSs released by the FSS, significant variations from chaebols’ traditional financial statements are revealed in such key financial variables as total assets, total liabilities, equity capital, revenues and profits. As the following table shows, for example, the top four chaebols in Korea have their sales and total assets reduced significantly in the new CFSs from those reported in their traditional financial statements, while their debt-equity ratios (excluding affiliated financial institutions) are much worse than previously reported. Furthermore, like other chaebols their operating income to total revenue ratios for non-financial affiliates are found to be very low, despite the fact that the Korean GDP recorded an impressive real growth rate of 10.7% in 1999. The operating performance of their financial affiliates turned out to be even worse.

Table 3: Changes in Financial Data due to CFS in 1999 New Operating Income Revenues Assets Debt-Equity Ratio to Revenue Ratio Hyundai -38% -14% 230% 5.5% Samsung -42 -18 194 14.4 LG -38 -17 273 5.8 SK -36 -28 228 6.3 The CFSs show that in 1999 the top four chaebols accounted for 75% of assets, 76% of debts, 72% of equity capital and 77% of the total revenues of the sixteen largest chaebols in Korea. The CFSs also revealed that many Korean chaebols registered very poor operating performances. For nine out of the sixteen chaebols, the interest coverage ratio (operating income divided by interest expenses) was less than one, meaning that their operating income in 1999 was not sufficient to cover even the interest expenses of that year, not to speak of the total debt service obligations. Among the top four, Hyundai’s financial performance was the worst, with its interest coverage ratio of only 0.91. VIII. Policy Changes towards the Foreign Direct Investments (FDI) in Korea In the history of Korea’s modern economic development from the early 1960s, FDI did not figure prominently in its development paradigm. The accepted wisdom of Korean economic policy makers during the early period was that FDI was a form of exploitation of cheap land, 17

labor and raw materials by global MNCs (multinational corporations) from industrialized countries. The economic elites in Korea thought that MNCs continued through FDI the old colonial pattern of exploitation that left the developing countries selling raw materials to and buying consumer goods from the industrialized countries. MNCs controlled technology and global marketing channels and formed alliances with their host governments to exploit the people and keep them down. Such line of thought among Korean government elites reflects the prevailing view of Third World policy makers in those years, due to the early history of FDI in developing countries. Unlike FDI between industrialized countries where MNCs take advantage of their comparative strengths in management and product mix for mutual benefits of both MNCs and host country consumers, the early FDI from industrialized countries into their colonies was in most cases for the explicit purpose of exploiting the raw material base of these colonies. Such pattern of FDI was especially pronounced in the cases of mining and plantation projects that were popular forms of colonial FDI. For example, Western oil companies would invest in new oil fields discovered in the jungles of South America or in the deserts of Arabia in order to supply crude oil to the modern oil refineries constructed back home. FDI in oil fields, copper mines, and plantations for tea, coffee and bananas in developing countries was mostly managed by Western expatriate staff that used to live with their families in enclaves carved out of their colonies. These enclaves had their own schools, stores, clubhouses and other recreational facilities for the exclusive use of the expatriate families and their friends, while local populations provided cheap source of manual labor as miners, field laborers, cooks, gardeners and nannies. This early pattern of FDI provided little positive spillover effects on the local economies of host countries, except for fattening the bank accounts of local rulers or tribal leaders who were paid handsomely by MNCs for the foreign investment concessions. It is not surprising, therefore, that newly independent countries in the developing world in the post World War II period did not look kindly toward both FDI and MNCs, and early Korean economic elites also succumbed to this naïve view of FDI. Consequently, the Korean government used to restrict FDI rather tightly through a variety of regulations including complicated foreign investment procedures and numerous sectors of the economy designated off limits or severely restricted to foreign investments. As a result, Korea was one of the least hospitable countries for FDI for many decades of its modern development history. As late as 1996, the cumulative inward FDI stock as a percentage of GDP was the lowest among Asian tiger countries at only 2.6% for Korea while the average for all developing countries stood at 15.6%. The comparable figures were 7.3% for Taiwan, 15.7% for Hong Kong, 22.3% for China, 48.6% for Malaysia and 72.4% for Singapore. In fact, Singapore was the first among developing countries in the 1960s to realize that the traditional view of FDI was outdated in the post-colonial period and that MNCs could bring in much needed capital, management know-how, technology, marketing skills and, most importantly, new jobs for host countries. To encourage FDI actively, Singapore established in 1961 the Economic Development Board, which provided a one-stop service for investors including MNCs. This enlightened view of FDI among Singaporean leaders was further solidified during Prime Minister Lee Kuan Yew’s sabbatical at Harvard, where, as recounted in his autobiography, he was most impressed among many illustrative professors there including Henry Kissinger, by the late Raymond Vernon of Harvard 18

Business School. Lee Kuan Yew says that Prof. Vernon taught him the modern and more realistic view of MNCs, which seek out FDI opportunities abroad as part of their global strategy of synergy, resulting in a positive win-win game for both host countries and MNCs.6 Unlike Singapore and other Asian economies such as Hong Kong and Malaysia, Korea is a very late and reluctant converter to finally recognize the many virtues of FDI in the postcolonial era. And such conversion took place not so much as a result of deliberate policy deliberation inside Korea but almost forced to open up to FDI by external economic factors. Only when Korea joined OECD in 1966, the government had to realign its FDI regime in line with international norms by updating its laws and regulations. Thereafter, when the Asian financial crisis hit Korea in 1997, policy makers in Korea finally realized the importance of FDI to secure long-term foreign capital on a more stable basis as compared to short-term bank loans and other traditional sources of foreign borrowings. In the early period of Korea’s economic modernization starting from the 1960s, the government encouraged the inflow of foreign capital in order to make up for the shortage of domestic savings and foreign exchange reserves. However, the government preferred foreign borrowing to FDI because of its fear of Korean industries being dominated by foreign entities in the case of FDI. Such xenophobic suspicion of foreign economic domination was deeply rooted in Korea’s bitter experience of Japanese colonization from 1910 to 1945. The government felt that foreign borrowing could bring in external capital but still under its own control. When two Free Export Zones were established at Masan in 1970 and Iri in 1974, the government allowed FDI in the light manufacturing export sector but with stringent performance requirements such as mandatory export quotas and technology transfer. Another factor working against FDI in Korea during this period was the relative cost structure of capital. During the period of inflation and high domestic interest rates, foreign borrowing at much lower nominal interest rates seemed far preferable for the Korean economy to foreign equity capital infusion through FDI. It is a basic financial truth that the nominal cost of equity financing is always much higher than the cost of debt financing, but a high financial leverage (or a high debt to equity ratio) has its own hidden cost in terms of greater volatility of profits, often leading to bankruptcies during an economic recession and declining revenues. For this reason, Western firms try to maintain a proper debt to equity ratio in order to minimize the bankruptcy risk. However, Korean businesses were generally both ignorant and dismissive of such leverage risks, believing in the government’s bailout during a time of crisis in the environment of crony capitalism. The bigger the size of a firm, the more audacious its management became in ignoring the leverage risk, firmly trusting its government to bail it out during a financial crisis. Such a mentality of “too-big-to-fail” syndrome was prevalent especially among large Korean conglomerates known as chaebol, which naturally relied more on foreign borrowing than on foreign equity investments.7

6 Raymond Vernon developed the famous theory of product life cycle and he was a leading scholar in the field of MNCs and foreign investments. When Lee Kuan Yew was at Harvard for one semester on his sabbatical as a sitting prime minister, I was a doctoral student at Harvard Business School where Prof. Vernon was one of my mentors and later I arranged for his visit to Korea to give a series of lectures to senior business executives.

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7 The too-big-to-fail (TBTF) concept also exists in the Western developed countries but it is mostly limited to large financial institutions, whose failures might lead to the widespread systemic risk far outweighing any moral hazard problem inherent in a government bailout.

It was the Asian financial crisis of 1997-98 that caused a sea change in Korea’s FDI regime. The new Kim Dae-jung government that took office in February 1998 embarked upon a major economic reform, including the promotion of FDI in Korea with the aim of overcoming the financial crisis and strengthening the international competitiveness of the Korean economy. Of course, the economic reform was a major condition of the $58.4 billion rescue financing package provided by multilateral institutions such as the IMF as well as a secondary line of credit from G-7 countries. One of the major objectives of the reform was to drastically improve Korea’s foreign investment climate in the recognition, belated but still laudable, that increased inflows of FDI are essential to rebuilding the economy’s competitive strength, because FDI brings with it new technology, advanced management know-how and strategic alliances with foreign partners. Thus, the Asian financial crisis changed the government stance regarding FDI from that of passive liberalization to one of active promotion. The new government’s adoption of sweeping measures to actively promote FDI is demonstrated by the enactment of the Foreign Investment Promotion Act (FIPA) of 1998, which focuses on creating an investor-friendly environment in Korea. With the passage of FIPA, Korea’s FDI regime was effectively liberalized. Currently, 99.8% of Korea’s economy is open to foreign investment, a level on par with that of other OECD countries. Only two out of a total of 1,060 sectors, radio broadcasting and television broadcasting, are closed to FDI, while 27 sectors such as some agricultural sectors and electricity business are partially restricted to FDI and they are scheduled to be further liberalized in the near future. Also, the amendment to the Foreigner’s Land Acquisition Act in 1998 completely removed any restriction on foreign ownership of land, property and dwellings. Thus, foreign-invested companies are being accorded the same rights and treatment as domestic companies. In addition to encouraging new business formation through FDI, Korea has now paved the way for FDI in existing businesses through both friendly and hostile M&As. With the passage of a bill in May 1998, even hostile M&As are now allowed in Korea in parallel with the global trend. During the 1990s the value of cross-border M&As globally rose by more than sevenfold from $151 billion in 1990 to $1.14 trillion in 2000. As of 2000, M&As comprised some 90% of total FDI in the world. In the case of Korea also, M&As have increased their share in total FDI inflows, exceeding greenfield FDI by a wide margin. Korea is not endowed with abundant raw material resources such as oil fields or mineral deposits to be developed through FDI. Instead, it has a plentiful supply of industrious and high-skill labor as well as a significant technology base and a well-developed social infrastructure. Korea also has the thirteenth largest economy with a relatively broad and sophisticated consumer market. These factors imply that Korea would be attractive to both manufacturing and services FDI aimed at both local and world markets. The tax incentives granted to FDI under FIPA and the Special Tax Treatment Control Act are primarily aimed at attracting high technology and large-scale manufacturing investment that creates jobs and generates increased tax revenues. New FDI businesses are eligible for special tax incentives if they are connected with high technology, service businesses that support the international competitiveness of domestic industries, and businesses located in a Foreign Investment Zone (FIZ). They are eligible for corporate and 20

income tax exemption for the first seven years and are entitled to a 50% tax reduction for the following three years. Corporate income tax on royalties for induced high technologies is exempted for five years. Also exempted are customs duties, special excise tax, and value added tax (10%) on capital goods imported within three years from the date of investment notification. Foreign investors are also free from double taxation if their home country is a signatory to a tax convention with Korea, which has signed such conventions with 53 countries as of early 2002. FIPA also encourages local governments to promote FDI. At the provincial level, foreign investors are exempt from local taxes for a period of eight to fifteen years. The FIZ program allows foreign investors to designate their preferred site for their business operations and to receive all the tax incentives and other benefits available to eligible investors. In order to qualify for a FIZ, new FDI manufacturing businesses should generate foreign investment of over $50 million, over 50% foreign ownership and creating over 1,000 new jobs, or over $30 million new investment and creation of over 300 new jobs in the Industrial Parks which are located in pre-designated areas in an effort to attract large-scale foreign investment in manufacturing industries. Currently, there are four national industrial parks, and the government plans to expand the existing areas as well as construct a new complex. Industrial parks offer factory sites at low prices, and rental fees there are reduced. Since the government purchases land for building an industrial park before renting it to foreign-invested enterprises, the initial costs for starting business there are reduced and the period for establishing a factory is shortened. In addition, a one-stop service is provided for establishment of factories. But a major shortcoming in the industrial park system is that foreign investors have no say concerning the specific business location. To overcome this shortcoming, the government has introduced the FIZ system. With approval from the Foreign Investment Committee, chaired by the Minister of Finance and Economy, local governments can designate certain areas as FIZs upon the request of foreign investors. As a testament to Korea’s new commitment to FDI promotion, two administrative vehicles were established to support foreign investment. The Korea Investment Service Center (KISC) was founded in April 1998 within the Korea Trade-Investment Promotion Agency (KOTRA) to provide one-stop service system for foreign investors with administrative services ranging from initial consultation to factory move-in. Foreign investors do not, in principle, have to obtain government approval prior to their investment in Korea. The first step is simply to notify the government of a foreign direct investment. KISC is authorized to accept the notification along with designated foreign and domestic banks. A KISC official operates as a proxy for the investor, taking care of the entire approval procedure involving relevant administrative institutions until a decision on the application is made. In order to address grievances and difficulties of foreign investors and foreign invested enterprises, the Office of the Investment Ombudsman (OIO) was established in October 1999, also within KOTRA. The word ombudsman is used in many fields to describe people who monitor sectors such as the media and politics. Japan set up the Office of Trade and Investment Ombudsman in 1982 to handle complaints from foreign and local firms concerning government regulations. The objective of the OIO is to address and resolve any difficulties pertaining to business and daily living conditions experienced by foreign-invested companies in Korea 21

through prompt aftercare service in collaboration with KOTRA and relevant government ministries. Along with the Ombudsman, an “Investment Home Doctor” program was also introduced. Each “Home Doctor” is assigned to a foreign-invested company to provide the company with various services such as solving grievances, providing business information, and obtaining business permits. The results of Korea’s liberalized FDI regime during the past four years have been rather impressive. According to one estimate, the total amount of FDI inflows into Korea during the four-year period of 1997-2001 was $52 billion, far exceeding the amount of $25 billion accumulated over the previous 35-year period of 1962-1996. While such statistics are impressive indeed, we have to be careful in interpreting the data, as there are three different estimates of FDI inflows: notification basis, arrival basis, and balance of payment (BOP) basis. FDI is defined as foreign equity investments of more than 10% of equity capital of foreign-invested companies in Korea as well as intra-company loans with maturities of five years or more. Notification and arrival basis measures are from the administrative records of the Ministry of Commerce, Industry and Energy (MOCIE), while the BOP measure is collected by the Bank of Korea (BOK) using both foreign exchange receipts and payments statistics maintained by the BOK and the MOCIE data. This BOP measure combines three elements: purchase of equity, retained earnings, and net lending from parents to subsidiaries. It is close to the arrival basis measure for most years and it is used broadly including the official IMF statistics contained in such IMF publications as the International Financial Statistics. Both the arrival and BOP basis measures are more realistic than the notification measure since some FDI projects are subsequently cancelled and withdrawn after their initial notification. On the BOP basis, the amount of FDI inflows into Korea reached the peak during 1999 and 2000, matching those heading for Japan, a far larger market with its GDP almost ten times that of Korea. However, FDI inflows into Korea sharply declined in 2001, reflecting a marked slowdown in corporate restructuring and thus much less opportunities for cross-border M&As. In terms of geographical origin of FDI inflows into Korea, the Japanese share experienced a precipitous decline from 16% of the total in 2000 to only 6% in 2001, while the U.S. share increased from 19% to 33% during the same period. The slowdown in FDI inflows has continued in 2002, especially with an 18% year-on-year decline during the third quarter. In comparison, the lion’s share of FDI inflows is destined for China and Hong Kong, while Singapore and Malaysia attract also a far bigger share of FDI per capita than Korea. With China’s entry into WTO in 2001, FDI flows into China are likely to accelerate still further. In the early years, many foreign investments in China were made with the main objective of penetrating the potentially large Chinese market with 1.2 billion people. However, foreign companies have quickly discovered that manufacturing plants in China can produce high quality products at much lower costs for global export markets as well due to the highly efficient work force with much lower labor costs. Thus, China has gradually become an important manufacturing base for many MNCs from around the world as a vital part of their global supply chain management. In recent years, China has become not only the major production center for

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labor-intensive goods but also for a growing array of high tech products as well.8 China has attracted FDI flows not only from American and European firms but also from Japan and increasingly in recent years from Korean firms that are in desperate search of lower labor costs with less labor militancy. Thus, China has become a major threat to Korea in attracting FDI inflows. How to compete with China in the fight to win FDI flows has become a major challenge for Korea. IX. Potential Lessons for Latin America and the Caribbean The Korean financial crisis of 1997-98 has taught us some valuable lessons that might prove useful for Latin America and the Caribbean in the increasingly integrated world. First, despite the fact that the flows of capital to Asia were originally touted as an example of the benefits of free international capital markets in directing resources to the most productive uses, yet in the aftermath of the crisis it was shown that free international capital flows would not necessarily lead to the most productive use of financial resources but instead to highly speculative and excessive investments in real estate and other massive projects of doubtful economic and financial value. Total returns on capital investments in Asia have in fact been lower than in most other regions of the world throughout the early and mid 1990s.9 Second, tight fiscal and monetary policies proved counter-productive in dealing with a modern financial crisis, triggered in part by massive and panicky capital outflows, in the current integrated and liberalized world economy. Rather than reversing capital flights, they ended up devastating otherwise viable businesses and sharply increasing unemployment. With the firm support of the U.S. government, the IMF initially forced crisis-stricken Asian countries such as Thailand and Korea to adopt tight fiscal and monetary policies, which exacerbated the crisis by further weakening the already fragile banking system by massive corporate bankruptcies and skyrocketing bad debts. Many economists, including those at the World Bank, have rightly criticized such policy approach by the IMF as initially worsening Asia’s problems rather than helping to solve them. Third, too hasty financial liberalization and capital market opening might be counter-productive, unless they are accompanied by a sound domestic financial system and a strong regulatory framework. Therefore, sequencing is the key to a successful liberalization regime. Before adopting a full-fledged policy of free capital flows, governments should first ensure the establishment of a sound domestic banking system along with an adequate regulatory and supervisory framework. Fourth, it has become clear that international investors have a short memory span. Even though the U.S. government and the IMF, along with international banks, warned developing countries of dire consequences if they rescheduled their foreign debts or otherwise treated foreign lenders badly, foreign bankers and investors would go back to those same countries as soon as they 8 “High Tech in China: Is It a Threat to Silicon Valley?” Business Week, October 28, 2002.

239 J. A. Kregel, “Derivatives and Global Capital Flows: Applications to Asia,” Working Paper No. 246, The Jerome Levy Economics Institute of Bard College, August 1998.

could sense an opportunity to make money. After the severe 1994-95 financial crisis, Mexico was able to tap international capital markets successfully in 1996. Barely a year after Malaysia was harshly criticized by international bankers and the Washington policy establishment for its unilateral currency and capital controls, the country was welcomed back in 1999 to international capital markets to issue as much as $1 billion in new bonds. One may conclude, therefore, that governments should not worry too much about all the scare talks of irreparable damages and permanent blacklisting of a country by the international banking community. Governments should do what is needed in their self-interest first. When their economies become strong again, international investors are likely to stream back despite any earlier displeasure shown by the international financial establishment. Fifth, a future financial crisis should be handled in such a way that private international lenders and investors also carry their fair share of responsibility. So far, private international lenders and investors have generally been “bailed out” at the taxpayers’ expense through the use of the funds provided by the IMF and various multilateral development banks. Such a practice has two problems. First, it is patently unfair that the general public should shoulder all the responsibility to clean up the economic debris of a financial crisis which was in part caused by the reckless and imprudent practices of international lenders and investors seeking to maximize their profits in various emerging markets. Higher expected returns in these emerging markets should also carry higher risks for the same investors and lenders, rather than always being bailed out with the public funds. Second, even more important than the issue of fairness is the issue of moral hazard. The way the recent financial crises from Mexico to Asia have been handled under the aegis of the U.S. government and the IMF has encouraged the very reckless behaviors of international lenders and investors to plant the seeds for even bigger future financial crises. It is time, therefore, to break this vicious cycle by also “bailing in” the private international lenders and investors in future financial crises.

Finally, it is important for a country or a region to discard hubris and to understand that, no matter how successful their economy might have been in the past, a sudden economic crisis can be triggered by any number of causes in this integrated world economy. For that matter, a country should not be contented or complacent when the Washington policy establishment and the international investment community heap praises on it. Before the 1997-98 crisis, those Asian countries that subsequently suffered their worst financial crises in their post-World War II history had been praised profusely for their impressive economic record by the IMF, the U.S. government and the international financial community. Barely two months before the crisis hit Korea, for example, the country was singled out for special praises as being different from other South Asian countries by senior IMF officials and others during the 1997 IMF-World Bank annual meetings held in Hong Kong. International credit rating agencies have done no better in this regard. In October 1997, Korea’s credit rating was double-A minus (AA-) but barely two months later in December 1997, its credit rating was downgraded by ten notches to single-B plus (B+). Throughout the world’s financial crises in fact, the international financial establishment and officialdom have proven to be equally gullible as your next-door real estate speculators in their blindness to an impending doom. The only big difference between the two is that the former can often walk away with only a slight dent to their reputation, while the latter usually suffer far more severely in financial terms. 24

One explanation for the failure to predict the Korean crisis is that previous crises in the Latin American region had largely been caused by such macroeconomic problems as fiscal or balance of payments crises, and analysts looking for similar weaknesses in Korea found few of the signs of a classic external crisis. In Korea, economic growth was relatively high; inflation remained low; the real exchange rate was not thought to be overvalued; the current account deficit was within a sustainable range; and the government fiscal position was strong. Moreover, the record of prudent and flexibly applied macroeconomic policies suggested that Korean economic policies would respond appropriately to a large shock. In the event, however, the Korean crisis was the result of excessive regulation and mismanagement of companies and banks, not an undisciplined government or poor macroeconomic fundamentals. From a broader perspective, Korea may also have been a victim of its own success. Although many observers were aware of the growing problems of the highly leveraged corporate sector and a weakened financial system, the fact that these weaknesses had existed for so long while Korea continued to grow rapidly may have created a sense of complacency and confidence that Korea would be immune to a crisis. Korea’s model of development worked remarkably well over a sustained period of time before the crisis. However, as Korea advanced and became more integrated with the global economy, the government- and chaebol-led system that had functioned so well during periods of rapid growth proved ill-equipped to deal with new types of shocks to what had become a more developed economy.

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