Financial Markets and Institutions (2-downloads)

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G L O B A L

The Perversion of the Financial Liberalization/Globalization

Process: Chaebols and the South Korean Crisis

Although there are similarities with the perversion of

the financial liberalization/globalization process that

occurred in many emerging market economies, South

Korea exhibited some particularly extraordinary ele-

ments because of the unique role of the chaebols,

large, family-owned conglomerates. Because of their

massive size—sales of the top five chaebols were

nearly 50% of GDP right before the crisis—the chae-

bols were politically very powerful. The chaebols’

influence extended the government safety net far

beyond the financial system because the government

had a long-standing policy of viewing the chaebols

as being “too big to fail.” With this policy in place,

the chaebols would receive direct government assis-

tance or directed credit if they got into trouble. Not

surprisingly, given this guarantee, chaebols borrowed

like crazy and were highly leveraged.

In the 1990s, the chaebols were in trouble: they

weren’t making any money. From 1993 to 1996, the

return on assets for the top 30 chaebols was never

much more than 3% (a comparable figure for U.S. cor-

porations is 15–20%). In 1996 right before the crisis

hit, the rate of return on assets had fallen to 0.2%.

Furthermore, only the top 5 chaebols had any profits:

the 6th to 30th chaebols never had a rate of return on

assets much above 1% and in many years had nega-

tive rates of returns. With this poor profitability and the

already high leverage, any banker would pull back on

lending to these conglomerates if there were no 

government safety net. Because the banks knew the

government would make good on the chaebol’s loans

if they were in default, the opposite occurred: banks

continued to lend to the chaebols, evergreened their

loans, and, in effect, threw good money after bad.

Even though the chaebols were getting substantial

financing from commercial banks, it was not enough

to feed their insatiable appetite for more credit. The

chaebols decided that the way out of their troubles

was to pursue growth, and they needed massive

amounts of funds to do it. Even with the vaunted

Korean national savings rate of over 30%, there just

were not enough loanable funds to finance the chae-

bols’ planned expansion. Where could they get it?

The answer was in the international capital markets.

The chaebols encouraged the Korean government

to accelerate the process of opening up Korean

financial markets to foreign capital as part of the lib-

eralization process. In 1993, the government

expanded the ability of domestic banks to make the

loans denominated in foreign currency by expanding

the types of loans for which this was possible. At the

same time, the Korean government effectively

allowed unlimited short-term foreign borrowing by

financial institutions, but maintained quantity restric-

tions on long-term borrowing as a means of manag-

ing capital flows into the country. Opening up short

term but not long term to foreign capital flows made

no economic sense. It is 

short-term capital flows that

make an emerging market economy financially frag-

ile: short-term capital can fly out of the country

extremely rapidly if there is any whiff of a crisis.

Opening up primarily to short-term capital, how-

ever, made complete political sense: the chaebols

needed the money and it is much easier to borrow

short-term funds at lower interest rates in the interna-

tional market because long-term lending is much

riskier for foreign creditors. Keeping restrictions on

long-term international borrowing, however, allowed

the government to say that it was still restricting for-

eign capital inflows and to claim that it was opening

up to foreign capital in a prudent manner. In the

aftermath of these changes, Korean banks opened

28 branches in foreign countries that gave them

access to foreign funds.

Although Korean financial institutions now had

access to foreign capital, the chaebols still had a prob-

lem. They were not allowed to own commercial banks

and so the chaebols might not get all of the bank loans

that they needed. What was the answer? The chaebols

needed to get their hands on financial institutions that

they could own, that were allowed to borrow abroad,

and that were subject to very little regulation. The finan-

cial institution could then engage in connected lending

by borrowing foreign funds and then lending them to

the chaebols who owned the institution.

An existing type of financial institution specific to

South Korea perfectly met the chaebols’ requirements:

the merchant bank. Merchant banking corporations

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Part 3 Fundamentals of Financial Institutions

began a cycle of raising the federal funds rate to head off inflationary pressures.

Although the Fed’s monetary policy actions were successful in keeping U.S. infla-

tion in check, they put upward pressure on interest rates in both Mexico and

Argentina. The rise in interest rates in Mexico and Argentina directly added to

increased adverse selection and moral hazard problems in their financial markets. As

discussed earlier, it was more likely that the parties willing to take on the most risk

would seek loans, and the higher interest payments led to a decline in firms’ cash flow.

Also consistent with the U.S. experience, stock market declines and increases in

uncertainty initiated and contributed to full-blown financial crises in Mexico, Thailand,

South Korea, and Argentina. (The stock market declines in Malaysia, Indonesia, and

the Philippines, on the other hand, occurred simultaneously with the onset of these

crises.) The Mexican economy was hit by political shocks in 1994 (specifically, the

assassination of the ruling party’s presidential candidate, Luis Colosio, and an upris-

ing in the southern state of Chiapas) that created uncertainty, while the ongoing reces-

sion increased uncertainty in Argentina. Right before their crises, Thailand and South

Korea experienced major failures of financial and nonfinancial firms that increased gen-

eral uncertainty in financial markets.

As we have seen, an increase in uncertainty and a decrease in net worth as a

result of a stock market decline increases asymmetric information problems. It

becomes harder to screen out good from bad borrowers. The decline in net worth

decreases the value of firms’ collateral and increases their incentives to make risky

investments because there is less equity to lose if the investments are unsuccess-

ful. The increase in uncertainty and stock market declines that occurred before the

crises, along with the deterioration in banks’ balance sheets, worsened adverse selec-

tion and moral hazard problems and made the economies ripe for a serious finan-

cial emergency.

At this point, full-blown speculative attacks developed in the foreign exchange

market, plunging these countries into a full-scale crisis. With the Colosio assassi-

nation, the Chiapas uprising, and the growing weakness in the banking sector, the

Mexican peso came under attack. Even though the Mexican central bank intervened

in the foreign exchange market and raised interest rates sharply, it was unable to

stem the attacks and was forced to devalue the peso on December 20, 1994. In the

case of Thailand, concerns about the large current account deficit and weakness

were wholesale financial institutions that engaged in

underwriting securities, leasing, and short-term lending

to the corporate sector. They obtained funds for these

loans by issuing bonds and commercial paper and by

borrowing from interbank and foreign markets.

At the time of the Korean crisis, merchant banks

were allowed to borrow abroad and were almost

virtually unregulated. The chaebols saw their oppor-

tunity. Government officials, often lured with bribery

and kickbacks, allowed many finance companies

(some already owned by the chaebols) that were not

allowed to borrow abroad to be converted into 

merchant banks, which could. In 1990 there were

only six merchant banks and all of them were 

foreign-affiliated. By 1997, after the chaebols had

exercised their political influence, there were 

30 merchant banks, sixteen of which were owned

by chaebols, two of which were foreign-owned but

in which chaebols were major stockholders, and

twelve of which were independent of the chaebols

but Korean-owned. The chaebols were now able to

exploit connected lending with a vengeance: the

merchant banks channeled massive amounts of funds

to their chaebol owners, where they flowed into

unproductive investments in steel, automobile produc-

tion, and chemicals. When the loans went sour, the

stage was set for a disastrous financial crisis.

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Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?

187

in the Thai financial system, culminating with the failure of a major finance com-

pany, Finance One, led to a successful speculative attack. The Thai central bank was

forced to allow the baht to depreciate in July 1997. Soon thereafter, speculative

attacks developed against the other countries in the region, leading to the collapse

of the Philippine peso, the Indonesian rupiah, the Malaysian ringgit, and the South

Korean won. In Argentina, a full-scale banking panic began in October–November

2001. This, along with realization that the government was going to default on its

debt, also led to a speculative attack on the Argentine peso, resulting in its col-

lapse on January 6, 2002.

The institutional structure of debt markets in Mexico and East Asia now inter-

acted with the currency devaluations to propel the economies into full-fledged

financial crises. Because so many firms in these countries had debt denominated

in foreign currencies like the dollar and the yen, depreciation of their currencies

resulted in increases in their indebtedness in domestic currency terms, even

though the value of their assets remained unchanged. When the peso lost half

its value by March 1995 and the Thai, Philippine, Malaysian, and South Korean cur-

rencies lost between one-third and one-half of their value by the beginning of 1998,

firms’ balance sheets took a big negative hit, causing a dramatic increase in adverse

selection and moral hazard problems. This negative shock was especially severe

for Indonesia and Argentina, which saw the value of their currencies fall by more

than 70%, resulting in insolvency for firms with substantial amounts of debt

denominated in foreign currencies.

The collapse of currencies also led to a rise in actual and expected inflation in

these countries. Market interest rates rose sky-high (to around 100% in Mexico

and Argentina). The resulting increase in interest payments caused reductions in

household and firm cash flows. A feature of debt markets in emerging-market coun-

tries, like those in Mexico, East Asia, and Argentina, is that debt contracts have very

short durations, typically less than one month. Thus, the rise in short-term inter-

est rates in these countries made the effect on cash flow—and hence on balance

sheets—substantial. As our asymmetric information analysis suggests, this deteri-

oration in households’ and firms’ balance sheets increased adverse selection and

moral hazard problems in the credit markets, making domestic and foreign lenders

even less willing to lend.

Consistent with the theory of financial crises outlined in this chapter, the sharp

decline in lending helped lead to a collapse of economic activity, with real GDP

growth falling sharply. Further deterioration in the economy occurred because

the collapse in economic activity and the deterioration in the cash flow and balance

sheets of both firms and households worsened banking crises. Many firms and

households were no longer able to pay off their debts, resulting in substantial losses

for the banks. Even more problematic for the banks were their many short-term lia-

bilities denominated in foreign currencies. The sharp increase in the value of these

liabilities after the devaluation led to a further deterioration in the banks’ balance

sheets. Under these circumstances, the banking system would have collapsed in the

absence of a government safety net—as it did in the United States during the Great

Depression. With the assistance of the International Monetary Fund, these coun-

tries were in some cases able to protect depositors and avoid a bank panic.

However, given the loss of bank capital and the need for the government to inter-

vene to prop up the banks, the banks’ ability to lend was nevertheless sharply cur-

tailed. As we have seen, a banking crisis of this type hinders the ability of the banks

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