Minsky said, “Stability is destabilizing”. This quote perfectly illustrates his paradox of tranquility: crises often build up when the economy is doing well. Who could have imagined, even for a moment, that a country like South Korea would face its worst financial crisis? In this context, we will look at the main features of the 1997 Asian crisis in South Korea. First, we will examine how it started, then how it spread and what its consequences were, and finally how it was managed.

The origins

The East Asian countries, including South Korea, experienced rapid economic growth from the 1970s to the 1990s. Thanks to generally cautious budget policies and high interest rates, South Korea was considered a model for many nations. The country aimed to attract foreign capital by reassuring investors about the stability of its exchange rate. The value of the won was pegged to the US dollar. As a result, South Korea’s GDP growth reached around 13% in 1983. Originally a country facing economic difficulties, it saw its situation improve thanks to large amounts of foreign investment, especially from the United States, as investors sought higher profits. Domestically, the real estate sector attracted household savings as well as foreign capital. In addition, the financial liberalization that began in the early 1990s made it easier for these foreign funds to enter the country. The 1997 crisis was a currency crisis. It began in Thailand and spread to several countries, including South Korea. This crisis displayed all the classic features of financial crises: high debt or even over-indebtedness, euphoria, herd behavior, and speculation.

The crisis worsened because banks kept granting loans and speculating on them, as they were highly profitable. They were lending blindly to households and entrepreneurs just to meet their targets. If you asked for a loan of 30,000 won, the banks might say: “Wouldn’t you prefer 40,000 won instead?” This led to an excessive flow of credit, beyond the real financing needs of the economy, much of which ended up in real estate projects. This is known as a speculative real estate bubble.

This crisis had several causes:

First, in the early 1990s, international investors borrowed in US dollars because the Federal Reserve had lowered its interest rates. Later, when US interest rates rose, the dollar appreciated. What is dangerous is if the dollar appreciates, and you guessed it, it has appreciated and therefore the won has depreciated losing about 55% of its value. The country’s foreign exchange reserves fell from 22 billion US dollars on October 31, 1997, to 6 billion by November 20. This triggered panic. As a result, foreign capital fled South Korea, and the most vulnerable banks and real estate companies went bankrupt. Speculators began selling their assets, leading to what is called debt-deflation. The devaluation of the won increased the country’s debt, creating a vicious cycle: as debt rose, loans decreased, which reduced consumption, and foreign capital continued to leave the country.

Second, South Korea liberalized its economy even though it lacked strong protective and regulatory institutions, within an international monetary system that was itself liberalized and dominated by the US dollar. Because of this lack of regulation, investors were able to speculate more. On top of that, a leverage effect appeared. Since the won depended on the dollar and the dollar appreciated, debts in dollars became harder to repay because they became more expensive. Finally, investors were able to withdraw their money easily because they knew a crisis was coming. As a result, other investors, seeing others leaving the market, were influenced to do the same, like a social convention. In other words, it was a collective belief that everyone had to follow, similar to J.M. Keynes’s beauty contest theory.

Now that we understand how the crisis started, let’s see how it spread.

The spread

South Korea was affected in September 1997. Several signs appeared before the crisis began. As mentioned before, people borrowed too much, and companies produced more than what the real economy needed. Big banks and chaebols (large family-owned business groups) went bankrupt. The crisis first spread within the financial sector. Banks stopped lending money to each other in the interbank market because they feared not being repaid. Also, there was a shadow banking system made up of institutions financing the economy outside of normal banks. These included bank subsidiaries and non-bank institutions like pension investment funds. They took big risks because they did not report their accounts clearly and avoided financial rules. Shadow banking was characterized by high risk-taking and very little regulation. Finally, with financial globalization, the crisis became a systemic risk because South Korea and other East Asian countries had strongly interconnected economies.

South Korea, which had the highest GDP growth rate among all OECD countries more than 8% on average from 1985 to 1995 and the lowest unemployment rate at 2% in 1996, saw its situation worsen quickly. Against the dollar, the won lost half its value in November 1997 alone. The big chaebols, like Daewoo (the country’s second largest) and Hyundai, faced huge difficulties, and the country’s global ranking fell from 24th to 55th. The unemployment rate quadrupled from 2% at the end of 1997 to 9% by early 1999.

Moreover, the credit crunch a slowdown in bank loans to households caused a drop in household consumption, which fell by 8.6% for food. This economic decline worsened South Korea’s social situation. The poverty rate doubled, reaching 20% of the population in 1998. Many families had to take multiple jobs to survive. Some sacrificed their children’s education because it was too expensive, leading to fewer school enrollments and some students dropping out of university to help their families financially. Also, some families fell into absolute poverty, which led to problems like alcoholism and drug use. This in turn caused more domestic violence against spouses and children, with some children even abandoned by their families.

Crisis regulation

To respond to this crisis, South Korea turned to the International Monetary Fund (IMF), which provided a financial aid package of about 21 billion dollars over roughly three years. The IMF put in place several strategies to save the country, using common economic policies.

First, a monetary policy was established. The goal was to temporarily raise interest rates to stabilize the won and prevent further depreciation and inflation. By increasing these rates, commercial banks also raised their rates, which led to a decrease in the demand for credit by economic agents and a reduction in the money supply. This caused economic activity to slow down, but inflation dropped. Once confidence returned, interest rates were lowered again.

Second, the Korean government implemented a strict fiscal policy. This aimed to fight inflation and reduce the trade deficit by managing the state’s budget that is government spending and revenues. This could mean increasing taxes and cutting investments and state aid to slow down the economy. These measures led to higher unemployment and slower growth. As a result, GDP dropped by 7% in 1998.

Then, it was necessary to strengthen banking supervision and regulation. Prudential regulation aims to reduce banks’ risk-taking to avoid costly crises for taxpayers. This can be done by introducing solvency ratios, mandatory capital requirements. The Basel agreements raised banks’ capital requirements from 2.5% to 4.5% and added a conservation buffer of 2.5% to the existing 8%. Another way to limit bank risks is to separate commercial banking activities from investment banking, reducing risk-taking by some banks.

Thus, financial institutions in default of payment are closed and those still profitable were rescued by the government. There is greater transparency in the financial, public and corporate sectors. As a result, financial markets quickly stabilized in early 1998, interest rates returned to low levels, and economic activity began to recover gradually. By 2000, South Korea recorded an 8% growth rate. Socially, they expanded social protection and introduced unemployment insurance.

In conclusion, we have seen that many factors led to a general crisis in the system, but institutions intervened in time and managed to save the country from bankruptcy. Given the dangers crises can bring, it is essential to understand them well because their costs are very high. To prevent future crises, it would be good to make progress and find new innovations that help to foresee and avoid them.

Narjesse Ahrrouq

Sources:

Excerpts from Chapter VII, “Asia in Search of a Better Future for Itself (and for the World)” from the book Money: From the Power of Finance to the Sovereignty of Peoples, by Rémy Herrera

The 1997 Asian Crisis, Lumni Education.

Recovery from the Asian Crisis and the Role of the IMF, prepared by IMF staff, June 2000.

South Korea: An Unprecedented Social Crisis, article from Le Monde Diplomatique published on January 15, 1997.

South Korea GDP (current US$) | Statistics from Perspective Monde.
Analysis of the book Can It Happen Again? by Minsky, Major Prépa.