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Effects of the Asian Financial Crisis on the Korean Economy: Some Further Empirical Evidence

Charles Harvie

School of Economics Faculty of Commerce

University of Wollongong Wollongong, NSW

Australia 2522

and

Mosayeb Pahlavani Faculty of Economics

University of Sistan and Baluchestan Zahedan

Iran

Abstract

Korea’s prolonged and remarkable period of economic growth and development came to an abrupt halt with the onset of the financial and subsequent economic crisis of 1997-98. Increasingly apparent structural weakness from the late 1980s and early 1990s were largely ignored while output and export growth continued unabated, but with global turbulence from the mid 1990s financial and economic conditions rapidly deteriorated. The paper presents empirical evidence demonstrating the significance of the crisis to structural breaks in key financial and economic variables for Korea. Based on the timing of these breaks the evidence presented indicates that the crisis initially affected the exchange rate and money supply, then GDP before impacting upon inflation and the interest rate. JEL classification numbers: E32, E44, E65, G18 Key words: Korean economy, Asian Financial Crisis, structural breaks. * Corresponding author, Faculty of Economics, University of Sistan & Baluchestan, Zahedan, Iran, Email: Pahlavani@hamoon.usb.ac.ir

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1. Introduction Few countries in history have attained economic development as rapidly as Korea

(World Bank, 1993). In a single generation this poor nation, consisting primarily of

subsistence farmers in the 1950s and early 1960s, had been transformed by 1996 into

the world’s largest producer of home appliances, the second largest producer of semi-

conductor chips, the second largest ship builder, the fifth largest car maker, the

eleventh largest economy in the world and the third largest in Asia, and the twelfth

largest exporter and trading nation (Harvie and Lee, 2003a, 2003b). Per capita

income doubled every eight years from the early 1960s rising from US$80 to

US$10,000 by 1996 (Australian Department of Foreign Affairs and Trade, 1999;

Harvie and Lee, 2003a, 2003b), and income remained relatively equally distributed.

The country’s attainment of OECD membership in December 19961 signified the

culmination of 35 years of extraordinary growth, and the economy’s coming of age.

Its model of economic development - state directed capitalism - became the envy of

other developing economies. Yet, less than a year after its accession to the OECD, the

country experienced a traumatic financial and economic crisis (Park, 1998; Park and

Song, 2000; Radelet and Sachs, 1998a, Radelet and Sachs, 1998b, Smith, 1998),

exposing major structural weaknesses in both the production and financial sectors.

The paper proceeds as follows. Section 2 conducts a brief overview of developments

in key financial and real variables in Korea in the build up to the financial crisis of

1997. The importance of the Asian financial crisis as a key structural break for

Korea’s financial and other macroeconomic variables is explored in section 3. Finally,

section 4 provides a brief summary of the major conclusions from the paper.

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2. Overview and build up to the financial crisis The seeds of the financial crisis in late 1997 were planted during the period of the

1990s and earlier (see, for example, Harvie and Lee, 2003a, b). The benign

macroeconomic environment of the 1990s hid growing financial weaknesses in both

the corporate and financial sectors, and an unprecedented accumulation of short term

debt. The latter increasingly exposed the country to financial turbulence in global and

regional markets. However, these fragilities were of little concern in an environment

of rapid growth of exports and output. With the deterioration of the country’s terms of

trade and resulting growth slowdown in export values in 1996 and 1997, however, the

highly over-leveraged corporate sector came under intense profitability and cash flow

pressures. In 1997 a number of chaebol became insolvent or had to seek protection

from creditors. An already shaky financial sector, arising from imprudent and

excessive lending to the chaebol, experienced a further sharp deterioration in its non-

performing loans. Government action to tackle this problem head on was lacking. By

October 1997 further pressure began to be strongly applied by international investors

on the currency as concerns over the third major fragility, excessive short term

foreign debt, came in to play. The ability of the country to meet its short-term interest

and debt repayments was questioned as useable foreign exchange reserves diminished

alarmingly. The consequence was the financial and economic crisis of 1997-98.

Table 1 summarises the turbulence experienced by a number of key financial and

related variables during the period of the 1990s. Interest rates, both nominal and real,

remained relatively high during the period, reflecting the country’s heavily protected

domestic financial markets (Kim, 1997; and Park, 1996). A combination of

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fluctuating nominal interest rates in conjunction with generally declining inflation

rates contributed to quite volatile real interest rates, and particularly so during the

latter half of the 1990s. These fluctuations contributed to major problems for the

heavily leveraged chaebols, and represented a further financial burden on less

favoured small and medium sized enterprises (Joh, 1999; Kwon, 1998; Lee and Lee,

1996).

INSERT TABLE 1 ABOUT HERE Domestic stock markets also experienced a roller-coaster ride during the 1990s. The

stock market price index remained relatively stable in the early part of the period

before increasing dramatically in 1993-1994, with an equally spectacular sustained

decline thereafter arising from a deteriorating external environment and corporate

sector performance (Harvie and Lee, 2003a). In contrast, the government’s fiscal

position remained strong. Starting with modest deficits during 1990-92 modest

surpluses were achieved from 1993-97, reflecting prudent monetary and fiscal

policies. In 1996, for example, Korea’s general government outlays and government

gross debt were the lowest of all OECD countries (see OECD, 1998, p.43). Its

financial balance was in surplus and its net debt was actually negative2.

Of critical significance was the rapid accumulation of gross foreign debt, particularly

from 19943. By the end of 1996 gross foreign debt was US$105 billion, equivalent to

20.1 per cent of GDP. This compared with a figure of around 12.6 per cent of GDP at

the end of 1990. The increase was mostly due to a significant deterioration in the

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trade deficit and expanded borrowing from overseas to meet increased investment. By

the end of 1997 gross foreign debt stood at US$120.8 billion, a total debt equivalent

to 25.3 per cent of GDP. Net foreign debt also increased steadily, and there were

increasing concerns about the country’s ability to meet debt repayments as well as

over the increasingly short-term nature of the debt. Short-term debt as a proportion of

total debt stood at 57.5 per cent by the end of 1996, up from around 30 per cent of the

total in the early 1990s (Corsetti, Pesenti and Roubini, 1998; Economist, 1998; Jwa

and Huh, 1998; Kwon, 1998; Lee, 1999; Park and Rhee, 1998; and Park, 1998). Four

factors contributed to the rapid build-up. First, the government expanded the scope

for short-term foreign currency borrowing in 1993, when it permitted enterprises to

borrow from abroad either directly or through Korean banks to finance imports of

capital goods4. While liberalising loans of less than one year, restrictions on long-

term overseas borrowing were maintained 5 (Jwa and Huh, 1998; Park, 1996).

Consequently, there was a dramatic rise in short-term foreign debt as Korean

financial institutions borrowed abroad to finance the investment boom (Economist,

1998). In contrast to some south-east Asian countries, however, the increased debt did

not lead to a speculative bubble in asset prices, instead foreign borrowing primarily

financed an expansion of industrial capacity that proved to be excessive. Second,

overseas borrowing was facilitated by a jump in the number of financial institutions

dealing in foreign currency, following the licensing of 24 merchant banks between

1994 and 19966 (Jwa and Huh, 1998; Park, 1996). Third, the widespread perception

that the won was undervalued during much of the 1990s encouraged borrowing from

overseas. Fourth, implicit government guarantees given to financial institutions

created a moral hazard that encouraged high levels of borrowing by Korean banks

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and lending by their foreign creditors (Borensztein and Lee, 1999). However, it was

not just the rise in short term debt that left Korea vulnerable to a financial crisis, but

the fact that it was combined with a lack of sound risk management at banks which

were inexperienced in the area of overseas borrowing (Kim, 1997). The new

merchant banks, in particular, took on high levels of liquidity and exchange rate risk7.

Moreover there was a lack of prudential supervision; basic regulations, such as

capital adequacy ratios for merchant banks, did not exist (Borensztein and Lee, 1999,

Kim, 1997).

Concern over the accumulation of short-term debt was compounded by the rapid

deterioration in the country’s foreign reserves, particularly from 1994, as short-term

debt increasingly exceeded foreign exchange reserves (see Table 1). Although foreign

exchange reserves accumulated rapidly during the 1990s to stand at US$33.2 billion

by the end of 1996, there was US$93.3 billion worth of short-term debt at the same

point in time. Worse still was the steep decline in foreign exchange reserves to

US$19.7 by the end of 1997. This was largely due to the Bank of Korea’s aggressive

intervention in the foreign currency market, aimed at stabilising the value of the won

in the face of the sizeable deterioration in the current account position (Park, 1998).

By mid December 1997 foreign reserves had fallen to only US$7 billion. It was,

therefore, not surprising that investors began losing confidence in the currency,

requiring the Korean authorities to turn to the IMF for financial assistance (Radelet

and Sachs, 1998a, 1998b).

The Korean currency experienced a continual depreciation against the US dollar in

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nominal terms during the early part of the 1990s. With the weakening of the dollar

itself against the Japanese yen, this implied a gain in competitiveness for Korean

products relative to those of Japan (Smith, 1998). However, from 1994 to 1995 the

won began to appreciate against the dollar, and with the dollar strengthening against

all major international currencies this resulted in a loss of international

competitiveness. The strengthening of the won against the yen had major implications

for Korea’s competitiveness vis a vis Japan in Asian markets. The effects were felt in

declining export demand for goods such as steel, chemicals, consumer electronic

products, petroleum products and plastics. This was offset, to some extent, by the

benefits that flowed to the more technologically advanced Korean industries that

were substantial importers of sophisticated Japanese capital goods and technology.

The Korean won depreciated sharply in nominal terms, by about 14 per cent, against

the dollar in 1996. While this improved the price competitiveness of Korean exports

it increased the repayment burden of foreign debt, and sharply increased the cost of

imported raw materials. The key reason for the depreciation included: the

strengthening of the US dollar; the increase in Korea’s current account deficit; and

the reduction in foreign capital inflows. More significantly for Korea’s exports the

won-yen exchange rate did not show signs of an improvement, with the depreciation

of the won against the yen offset by a sharp drop in the value of the yen against the

dollar. With the onset of the financial crisis in 1997 there was a dramatic decline in

the nominal value of the won relative to the US dollar, year on year, by the end of

1997 by some 91.7 per cent (Park and Rhee, 1998).

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3. Structural breaks and the importance of the Asian financial crisis for Korea

This section utilises quarterly time series data covering the period from 1990 to 2006

for the Korean economy to test for the existence of structural breaks. As discussed in

the previous section the period of the 1990s was one of intermittent economic

turbulence, with the likelihood of resulting structural breaks. The most obvious of

which being the effects arising from the Asian financial crisis of 1997 and,

subsequent to this, the tech wreck of 2000-01 and the credit card bubble of 2001-02

(OECD, 2005). The empirical results presented in this section are based upon the

Zivot and Andrews (1992) test for stationarity of time series data.

The macroeconomic series examined consists of the natural logs of quarterly

observations for: real GDP (GDP), the nominal exchange rate (ER), broad money

(BM), currency in circulation (CUR), the interest rate (IR) and consumer price index

(CPI). The quarterly time series data utilised covers the period 1990Q1-2006Q4.

Zivot-Andrews Unit root test in the presence of a potential structural break

As is well known the issue of structural change, and its consequential implications for

structural breaks, in macroeconomic time series data must be robustly addressed in

order to ensure non spurious results of unit root tests of such data. There can, of

course, be many reasons for structural change, and these can include such diverse

circumstances as economic crises, policy changes or regime shifts. For this reason it

is extremely important to test the null hypothesis of structural stability against the

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alternative of a one-time structural break. If potential structural changes are not

allowed for in the specification of an econometric model but are, in fact, present, the

results may be spurious because they can be biased towards the erroneous non-

rejection of the non-stationarity hypothesis (Perron, 1989; Perron, 1994; Perron,

1997; Leybourne and Newbold, 2003; Pahlavani, Valadkhani and Worthington, 2005;

Harvie and Pahlavani, 2006).

Perron’s (1989) key assumption is that the break date of the trend function is fixed

(exogenous), and chosen independently of the data. In fact, traditionally, the time of

any structural break was always assumed to be known a priori in accordance with the

underlying asymptotic distribution theory. However, Christiano (1992) and others

have criticised this approach, arguing that considering the timing of the break as an

exogenously known event invalidates the distribution theory underlying conventional

testing (Vogelsang and Perron, 1998). In response, a number of studies, including

Zivot and Andrews (1992), Perron (1994, 1997), Lumsdaine and Papell (1997) and

Bai and Perron (2003), to name just a few, have proposed different ways of

estimating the time of the break endogenously. These studies have shown that this

endogenous approach lessens the bias in the usual unit root tests.

Zivot and Andrews (hereafter ZA) (1992) propose a testing procedure where the time

of the break is estimated rather than assumed as an exogenous phenomenon. By

endogenously determining the time of structural breaks they argue that the results of

unit root hypotheses previously suggested by earlier conventional tests, such as the

widely-employed Augmented Dickey-Fuller (ADF) (Dickey and Fuller, 1979, 1981)

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test or the Perron (1989) methodology, may be reversed.

The theoretical underpinning of the Zivot-Andrews model is now described and then

the empirical results are reported. In this methodology, Tb (the time of break) is

chosen to minimize the one-sided t-statistic of α=1 in equations 1 and 2. In other

words, a break point is selected which is the least favourable to the null hypothesis.

The Zivot and Andrews (1992) model endogenises one structural break in a series

(such as yt) as follows:

H0: 1t t ty y eμ −= + + (1)

H1: 11

ˆ ˆˆ ˆˆ ˆ ˆ ˆ ˆ( ) ( )k

t t b t b t j t j tj

y DU T t DT T y c y eμ θ β γ α − −=

= + + + + + Δ +∑ (2)

Equation (2), which is referred to as model C by ZA, accommodates the possibility of

a change in the intercept as well as a trend break. ZA also consider two other

alternatives where a structural break impacts on the intercept only (model A) or trend

only (model B). Model C is the least restrictive compared to the other two models;

we thus base our empirical investigation on this model. In equation (2) DUt is a

sustained dummy variable capturing a shift in the intercept, and DTt is another

dummy variable representing a break in the trend occurring at time Tb where DUt=1

if t > Tb, and zero otherwise and tDT is equal to (t-Tb) if (t > Tb) and zero otherwise.

The null hypothesis is rejected if the α coefficient is statistically significant. The

computations presented in this study were conducted by means of the RATS program.

More specifically, the ZA test asserts that Tb is endogenously estimated by running

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the above equation (2) sequentially in order to allow for Tb to be in any particular

year/quarter with the exception of the first and last years/quarters. The optimal lag

length is determined on the basis of the Schwartz Information Criterion (SIC), AIC or

t-test (the use of the most significant t ratio in the literature is referred to as the

general to specific approach). Using the ZA procedure the time of the structural

changes (impacting on both the intercept and the slope of each series) is detected

based on the most significant t ratio forα̂ , that is ˆtα . The results for the variables and

data series utilised in this study using the ZA test are presented in Figure 1. The

lowest value for t̂α in each graph determines the Tb. The estimated coefficients for

equation (2), together with the corresponding Tbs for each of the variables under

investigation, are presented in Table 2.

INSERT TABLE 2 ABOUT HERE

The ZA test results are somewhat mixed as two out of the 6 variables, i.e. LnIR and

LnCPI, are not stationary, while the remaining four variables become stationary.

Given the fact that all of the estimated coefficients for the indicator and dummy

variables are statistically significant for all of the variables under investigation, one

can argue that the estimated structural break dates are indeed significant. The

corresponding time of the endogenously determined structural break for each variable

is shown in the second column of Table 2 (see also Figure 1). It is interesting to note

that the most significant endogenously determined structural breaks for the variables

under investigation closely correspond to the Asian financial and economic crisis of

1997-988. It can be observed that the one time most significant structural break for the

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variables LnER and LnCUR occurred in 1997Q4, the height of the financial crisis and

before the roll-over of short term debt had been agreed with international creditors,

while for LnGDP the structural break occurred in 1998Q1 which can be characterised

as the quarter in which the severe economic downturn triggered by the financial

turmoil occurred. Of the remaining macroeconomic variables the structural break for

LnCPI and LnIR occurred in 1998Q4, when the economy was experiencing signs of

recovery from the economic downturn.

INSERT FIGURE 1 ABOUT HERE

The empirical results have intuitive explanatory appeal. An interpretation of these

results would suggest that the financial turbulence of 1997Q4 impacted more rapidly

upon primarily financial variables such as the exchange rate, broad money and

currency in circulation1. Interestingly enough, however, the interest rate appears not

to have been adversely affected at this time, and this could be due to: government

attempts to prevent a significant rise in the interest rate that would only intensify the

economic downturn; the rapid agreement with the IMF for a financial rescue

package; as well as rapid agreement with international banks to roll over and increase

the maturity structure of existing short term debt in early 1998. Adverse financial

developments then impacted upon the real sector, in this case with a relatively short

lag due to its intensity, resulting in adverse effects on GDP by the first quarter of

1998. Only later in 1998Q4, with recovery of the economy underway, did prices

(CPI) and the interest rate demonstrate significant change.

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4. Summary and conclusions

The Korean economy achieved remarkable economic outcomes over three decades

until the outbreak of the Asian crisis in 1997-98. As indicated by the empirical

evidence presented in this paper the financial and economic crisis of 1997-98 was by

far the most traumatic event to affect the Korean economy since its period of rapid

economic growth and development from the early 1960s. The country has,

subsequently, been subject to further turbulence during the early part of the new

millennium (tech wreck), but this pales into insignificance in comparison to the

country’s experience of the late 1990s.

In addition, the empirical results, focusing upon endogenously determined structural

breaks for key macroeconomic variables, provide evidence as to the sequencing of

the impact of the crisis on the economy. Not surprisingly, this was felt initially in

financial markets, specifically for the exchange rate and monetary aggregates such as

broad money and currency in circulation, then upon real GDP and then, during the

recovery phase, the interest rate and consumer price inflation.

1 From the resulting banking crisis and insolvency of many domestic banks.

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Table 1 Financial Indicators for Korea 1990-1997

1990 1991 1992 1993 1994 1995 1996 1997 GDP Real Growth Rate (%) 9.0 9.2 5.4 5.5 8.3 8.9 6.8 5.0

Investment rate (% of GNDI) 37.6 39.8 37.3 35.4 36.5 37.3 38.1 34.4

Saving rate (% of GNDI) 37.5 37.3 36.4 36.2 35.5 35.5 33.8 33.4

CPI (%) 8.5 9.3 6.3 4.8 6.2 4.5 4.9 4.5 Government fiscal balance (% of GDP) -0.7 -1.6 -0.5 0.6 0.3 0.3 0.5 0.3

Interest Rate (%): Corporate Bond Yields 16.5 18.9 16.2 12.6 12.9 13.7 11.8 13.4 Stock market price index (composite stock price index (KOSPI), Jan 1980=100)

696 611 678 866 1027 883 651 376

Total debt (% of GDP) 12.6 13.3 13.5 12.7 14.1 16.0 20.1 25.3 Short term debt (% of total debt) 30.9 28.2 27.1 25.8 43.6 54.2 57.5 39.3

Short term debt/foreign exchange reserves (%) 74.5 84.2 71.7 61.9 126.4 146.1 200.6 273.1

Gross External Debt (US$bill.) 31.9 39.3 42.6 43.9 56.9 78.4 104.7 120.8

Net External Debt (US$bill.) 4.9 12.5 11.0 7.9 10.3 17.1 34.7 55.7

Foreign Exchange Reserves (US$bill.) 14.5 13.3 16.6 19.7 25.0 31.9 33.2 19.7

Gold and Foreign Exchange Reserves (US$bill.)

14.8 13.7 17.2 20.3 25.7 32.7 33.2 20.4

Exchange rate: (Won/US$)(year end) 716.4 760.8 788.4 808.1 788.7 774.7 884.2 1695.0

Real exchange rate (1990=100) (year end) 100 99 94 93 91 88 88 157

Sources: IMF; Bank of Korea; Korea Development Institute.

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Table 2. The Zivot-Andrews test results: break in both intercept and trend1

Variable

Description Symbol Tb K2 ˆtα 3 Inference Corresponding break time

Real GDP LnGDP 1998:01 1 -6.024 Sta

Asian financial crisis – economic downturn

Exchange rate

LnER

1997:04

0

-7.914

Sta

Asian financial crisis – financial turbulence

Broad Money (M2) LnBM 1997:04 3 -4.894

Sta

Asian financial crisis – financial turbulence

Currency in Circulation LnCUR 1997:04 1 -5.174 Sta Asian financial crisis – financial turbulence

Interest Rate LnIR 1998:04 3 -4.71 UR Recovery from the Asian financial and economic crisis

Consumer price Index

LnCPI

1998:04

3

-4.28

UR

Recovery from the Asian financial and economic crisis

Notes: (1) The computations were conducted using the RATS program. (2) The optimal lag length (K) is determined by the general to specific t- test, or AIC and SBC. (3) Critical values at the 1, 5 and 10 per cent levels are -5.57, -5.08 and -4.82, respectively (Zivot and Andrews, 1992). (4) The corresponding null is rejected at 5 per cent or better. Sources: The Bank of Korea (2006), Korea National Statistical Office: http://kosis.nso.go.kr and authors.

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Figure 1. Plots of the Estimated Timing of Structural Breaks by The ZA Procedure

Zivot-Andrews Unit Root Tests for LGDP

1991 1993 1995 1997 1999 2001 2003 2005-6.5

-6.0

-5.5

-5.0

-4.5

-4.0

-3.5

-3.0

-2.5

Zivot-Andrews Unit Root Tests for LNCPI

1991 1993 1995 1997 1999 2001 2003 2005-4.5

-4.0

-3.5

-3.0

-2.5

-2.0

-1.5

Zivot-Andrews Unit Root Tests for LER

1991 1993 1995 1997 1999 2001 2003 2005-8

-7

-6

-5

-4

-3

-2

-1

Zivot-Andrews Unit Root Tests for LNBM

1991 1993 1995 1997 1999 2001 2003 2005-5

-4

-3

-2

-1

0

1

21

Zivot-Andrews Unit Root Tests for LNCUR

1991 1993 1995 1997 1999 2001 2003 2005-5.5

-5.0

-4.5

-4.0

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0Zivot-Andrews Unit Root Tests for LNIR

1991 1993 1995 1997 1999 2001 2003 2005-4.75

-4.50

-4.25

-4.00

-3.75

-3.50

-3.25

-3.00

-2.75

-2.50

Note: the numbers on the vertical axis are t ratios for ˆtα . Source: Authors’ calculations.

22

Footnotes 1 An officially stated objective of the government in 1993. 2 Of all the OECD economies only Norway also had a negative government net debt, which was larger than Korea’s, and only Norway had a government financial surplus which was again larger than Korea’s. This position, however, deteriorated considerably from 1998 with the onset of the economic crisis and the fiscal commitments required by the government to re-capitalise the banking sector in particular. 3 This also corresponds with developments in international capital markets. After 1994, following the Latin American financial crisis, capital inflows into the emerging market economies of East Asia noticeably increased. 4 This move reflected the government’s strategy of beginning capital account liberalisation with trade related financial flows, which were not considered to be a threat to the conduct of monetary policy based on quantity controls. Direct overseas borrowing was limited to four categories of borrowers: SMEs; companies investing in public infrastructure projects; subsidiaries of foreign companies in technology based business areas; and companies paying foreign debt prematurely. For indirect borrowing through Korean banks, SMEs could borrow 100 per cent of the value of capital good imports. For large firms borrowing was limited to 90 per cent in manufacturing and 80 per cent in services until May 1995, when the ceiling was lowered to 70 per cent. 5 Those wishing to obtain long-term foreign loans had to provide detailed information and obtain the approval of the Ministry of Finance and Economy, while short term borrowers faced no such requirement. 6 The merchant banks had previously operated as finance companies, which were not allowed to deal in foreign currencies. After becoming “merchant banks”, they continued to operate as short-term finance companies. In addition, commercial banks opened 28 foreign branches between 1994 and 1996. 7 The liquidity risk reflected a maturity mismatch - a high ratio of short-term liabilities to assets. For the merchant banks, 64 per cent of their borrowings were short term while 85 per cent of their loans were long term (Chang, Park and Yoo, 1998). The foreign exchange risk was due to the failure of most corporations to hedge their foreign currency loans. Consequently, the depreciation of the won resulted in a deterioration of the banks’ balance sheets.

8 A recent study by Harvie and Pahlavani (2006), employing the Innovational Outlier (IO) and Additive Outlier (AO) models and quarterly macroeconomic data for the Korean economy covering the period 1980Q1-2005Q2, concluded that, after allowing for one structural break, the majority of endogenously determined structural breaks coincided with the effects of the financial and economic crisis of 1997-98.