A Tale of Two Crises: Korea’s Experience with External Debt ManagementPaper Prepared by

Professor Yung Chul ParkSeoul National University

UNCTAD Expert MeetingDebt Sustainability and Development Strategies

Korea’s Experience

Small and large financial crises: 1968-1969; 1974-1975; 1979-1980; 1991-1992;

1997-1998. In each case the crises were preceded by:

An investment boom A growing current account deficit in proportion to

GDP A real effective appreciation of the currency

Developments leading up to the 1979-1980 crisis Export promotion strategy

Investment boom Dramatic rise in inflation in 1980 Appreciation of the real effective exchange

rate Slowing of growth in 1979

Additional Developments

Oil crisis 1979 Deterioration of Terms of trade

Assassination of President Park in 1979 Deep Recession in 1980

Contraction of investment Poor Harvest

Increase in current account deficit

1979-1980 Crisis

Deep Recession Large current account imbalance Crisis in the informal credit market Total debt as a proportion of GDP rose by

more than 10 percent in 1980

Crisis Response and Management Devaluation of the won vis-à-vis the US dollar

(27 percent in 1980) Move to a managed float Growth-first strategy

Spending out strategy Expansionary fiscal policy High growth of M2 and M3

Recovery and Shift to Stabilization Inflation begins to subside in 1981 Current account deficit shrank to 3.3 percent

of GDP by 1982 Resumption of double digit growth in 1983 Shift to stabilization policies 1983-1988

Reversal of monetary and fiscal policies Total external debt remained over 47 percent

of GDP Heavily laden with short term loans

1997-1998 Capital Account Crisis

Investment Boom prior to the 1997-1998 Crisis Steady economic growth (1994-1997) Strengthening of the yen Financial liberalization and market opening Movement to foreign countries as foreign

direct investors High accumulation of foreign debt of

domestic firms

Bursting of the Investment Bubble Depreciation of the yen (Q3 1995) Deterioration Korea’s of terms of trade Real effective exchange rate appreciation (Q3 1995) Slowing of the economy in second half of 1996

Industrial groups slow to adjusting investment and output Rising inventories Accumulation of debt

Commercial Banks less willing to meet credit needs

Factors contributing to financial market collapse 1997 Slowdown of export growth Deterioration of terms of trade Soaring levels of corporate bankruptcies Rapid rise in non-performing loans of financial

institutions (Dec 1996-June 1997)

Additional factors contributing to collapse Pending presidential elections (Dec 1997)

Political uncertainties prompt capital flight Unclear exchange rate policy Defense of the won under pressure to

depreciate Fall in the Bank of Korea’s reserve holdings

Repeated lowering of sovereign credit rating Contributed to further the worsening of market

sentiment and foreign exchange rate depreciation

Management and Recovery of 1997-1998 Crisis Government reform package (19 Nov. 1997) IMF Bailout (3 Dec 1997)

Package $21 billion Conditionality Response to bailout package

Emergency financing program (24 Dec 1997) Additional funds ($10 billion) Government guarantee on private debt

Macroeconomic Policy Adjustments Initial tightening of monetary and fiscal policy The consequential increase in interest rates contributed to

widespread bankruptcies Reversal of fiscal and monetary policies in the face of a deeper

recession to more accommodative stance.

Strong contraction of GDP in 1998 to -6.9 percent growth

Rise in inflation (7.5 percent) Strong depreciation of the won vis-à-vis the dollar Rapid Recovery

Expansion of growth by 9.5 percent in 1999 Current account surplus in 1998

Large increase in net exports Decline in import demand

1997-1998 Crisis

Rapid Recovery

Higher level of openness fueled recovery: Large depreciation Large trade sector and export orientation

Flexibility of labor market Wage adjustments Reallocation of resources from non-tradeables to

the tradeables sector Strong global economy

Improvement in terms of trade in 1999 Appreciation of the yen

Similarities across crises

Crises were in part precipitated by an investment boom financed by foreign borrowing.

Rapid recovery Similar ratios of external debt to GDP Rigid foreign exchange rate systems

exacerbated the crises Economic fundamentals Aggressive export promotion policies

Differences between crises

First case 1979-1980 Capital account

transactions were tightly controlled

No capital flight Continued willingness to

finance the CA by international financial market

Spend-out policy adopted Expansionary monetary

and fiscal policy

Second case 1997-1998 Capital account

deregulation and freer movement of capital

Capital flight IMF package

Tight monetary and fiscal policy in concert with devaluation of the exchange rate

Policy response (expansionary/contractionary)

Economic environments Economic liberalization Market deregulation

Differences between crises