Term Paper Proposal s1

Study on Financial Crisis in Mexico and Korea : What we have learned from crisis in the 90s

Kangkook Lee

1. Introduction

Neo-liberal economic policies like liberalization and deregulation have been in fashion after 1980s and recommended as measures for economic development in many developing countries. But the experience in Mexico and Korea in the 90s shows that those policies in particular financial liberalization and capital account opening do never lead to the automatic economic development. Rather, they may lead to serious financial and currency crisis in both of countries. This paper is aimed at doing comparative study on the financial and currency crisis in Mexico and Korea, focusing on financial liberalization. Besides, we will examine what kind of structural problems those countries had and how the change of power relationship was related to these neoliberal policies. In both of countries the government adopted financial market opening without proper supervision system when there were serious structural problems in the economy. The change of domestic and international power relationship affected this process and made structural problems more and more serious. It led to rapid inflow of foreign capital making the financial sector very vulnerable and at last shock of the economy end up with sudden outflow of foreign capital, finally the crisis. This experience warns that developing countries should be careful in financial liberalization when the short-term capital movement is so rapid with financial globalization and the role of the state to regulate it properly and tackle structural problem is essential. However, the restructuring after the crisis just led to the adoption of more far-reaching neoliberal policies, which also reflects the power relationship after the crisis, only to raise more serious concern. The first section will examine the crisis in Mexico covering financial liberalization and onset of the crisis and the second one about the Korean crisis also focusing on careless financial opening and problems in industrial sector. We will show how neoliberal policies like liberalization or deregulation led to increase in debt, which made these countries vulnerable. And we will analyze restructuring policies after the crisis. From the experience in two countries, we can get important lessons to prevent financial crisis when financial capital was globalized so much and understand a proper role of the state for economic development.

2. Mexico : failure of long neoliberal restructuring

2.1. Neoliberal Restructuring after 1982

Mexico already suffered from serious debt crisis in 1982 that was mostly related to expansive government macroeconomic policy with serious fiscal deficit and inefficient import substitution strategy as well. Before the crisis, the Mexican government took a strong stance of import substitution to promote nationalist economic development for several decades. But the government was not autonomous and capable and the intervention into the economy like strong financial control and public firms were never effective. It went astray under the strong interest of social groups including capitalists and workers. The competitiveness of industry in Mexico grew weaker under the strong government protection and profligate fiscal policy due to demand of social groups led to chronicle inflation and high public and foreign debt. In Mexico, though the government intervened into the economy heavily before 1982, it could not discipline the private sector and rent-seeking activity detrimental to the economy was predominant in the course of development. The debt crisis of 1982 was a watershed of the Mexican economy. The crisis blew off the former development strategy and the government policies turned to reduction of state intervention into the market for stabilization, under the strong pressure of the international financial institutions like the IMF. They demanded the Mexican government to implement market driven restructuring policy when giving the fund to Mexico to address serious foreign debt problem. After debt crisis of 1982, the del la Madrid government tried to implement several policies like privatization of public firms and cutdown in subsidies to accomplish fiscal discipline. The government started privatization program in 1984 and intensified it in 1989 starting with small manufacturing firms to public utilities. By 1994, approximately 80% of state owned enterprises had been privatized. It also changed the development strategy to export promotion giving up former import substitution strategy and joining the GATT. Coverage of nontariff barriers was had been reduced from 90% of imports in 1986 to 19% of imports in 1994 and tariff range decreased continuously. As for exchange rate policy, since depreciation and expansive macro economic policy led to serious hyper-inflation in the 80s, the government pegged peso to dollar in 1988 to mitigate inflation problem. With the burden of foreign reserves, the government adopted crawling peg system in January of 1989 and in 1991 floating band system that the exchange rate floats inside a certain band was chosen. The neoliberal restructuring showed stop-go cycle due to strong interest of workers and farmers, and bargaining with international financial institution about foreign debt rescheduling. But since the middle of 1980s, Mexico had been a model country of neoliberalist reform that adopted extensive restructuring measures all over the economy including trade and financial liberalization, privatization and deregulation.1 This gained more momentum in the 1990s with Brady plan for debt rescheduling and structural adjustment program tied to it.

Table 1. Major macroeconomic indicators in Mexico (%)

80-86 87 88 89 90 91 92 93 94 GDP growth 2.2 1.9 1.2 3.3 4.5 3.6 2.8 0.6 3.5 Inflation 60.6 131.8 114.2 20.0 26.7 22.7 15.5 9.8 7.0 CA/GDP -1.1 3.1 -1.4 -3.0 -3.2 -5.3 -7.9 -6.6 -7.9 Debt/GDP -- 78.4 58.0 45.7 43.6 40.2 34.7 34.7 -- F/GDP -10.5 -15.0 -10.9 -5.0 -2.8 -0.5 1.6 0.3 -0.7

Note : CA means current account and balance and F means fiscal account balance.

1 Behind these policies there was social agreement between, the government, labor unions and capitalists called ‘pacto’ in an attempt to guide prices and wage increase. This social agreement reappeared after the crisis of 1994. In general, the Mexican economy was continuously changed through the 80s after the crisis of 1982 and this current gained more momentum in the early 90s. With these policies the Mexican government succeeded in stabilizing serious inflation and achieving fiscal soundness with economic growth to some extent. But high exchange rate and import liberalization raised serious current account deficit problem, most of all, despite neoliberal restructuring and reduction of state intervention, the government failed in establishing sound monitoring system over private sector like financial institutions.

2.2. Financial Liberalization and Capital Inflow in the 90s

In response to the debt crisis in 1982, the government undertook urgent measures in financial sector like commercial bank nationalization and control of capital flight in Mexico. Since then, efforts to change financial system with financial liberalization and privatization came up on and on through the 1990s, which made the Mexican economy vulnerable and led to growth of foreign capital inflow.2 These measures were exactly in line with neoliberal restructuring all over the economy based on IFIs’ demand and financial capitalist’s interest and neoliberal bureaucrats. First, the de la Madrid government intended to complement financial mediation of nationalized commercial banks allowing stock brokerage to broker securities so-called ‘parallel banking system’ in 1982. These brokerages were owned by former bankers and it they reaped great profit during this process. The government also issued Cetes, or treasury bills with competitive yields from 1985 to finance fiscal demand, which gave the private brokerages good fortune. The Salinas government adopted more far-reaching financial liberalization policies including privatization of commercial banks and foreign capital account deregulation. In 1988, it let banks compete with brokerages by offering ‘banker’s acceptances’,

2 About financial liberalization, while neoclassicals argue that it will lead to economic efficiency, structuralists are against this thoery mentioning efficiency of informal financial market and harms of liberalization. But both of theories have limits and are hard to be proved. Grabel interestingly argues financial liberalization and especially opening can lead to speculation-led development and economic instability based on post-Keynesian theories (Grabel, 1998). This line of argument can be applied to financial liberalization in Mexico and Korea in the 90s. commercial paper with a bank guarantee and deregulate banks interest rates to help them to compete with private brokerages. Government directed lending or policy loan by banks was scrapped and reserve requirements were lowered in 1989 and lifted for new deposit in 1991, to give banks more freedom. After this deregulation, the government privatized 18 banks during 1991-1992 mainly to private brokerages with several measures to limit tied loans and concentration of ownership. The privatization was orderly and rapid, above all it raised a windfall of over $12 billion with which the government could decrease foreign debt and increase reserves. However, though the new owners knew little about banking, newly privatized banks were eager to go into new business like housing loans, consumer credit, and reversed mortgages. As foreign interest rate was lower than domestic one, the privatized banks increased foreign borrowing and the government responded with several regulation on it like limit of short-term foreign-currency liabilities to 10% of total liabilities and 15% liquidity ratio on short-term liabilities in foreign currency. But the regulation was not effective that foreign borrowing increased in line with increase in total loans. In addition, banks got more funds indirectly from foreign investors through selling government securities to them.3 Financial liberalization combined with capital account deregulation in the early 90s, we will examine below, generated lending boom to private sector and demand of government securities.

Table 2. Increase of liability of the banks in Mexico (billions of dollars)

1989 1990 1991 1992 1993 1994 Domestic Currency 58.42 75.19 101.18 122.47 145.08 166.30 Foreign Currency 45.93 44.21 50.66 53.31 62.50 75.70

Source : Sachs et al.,(1996)

However, it is hard to say financial liberalization raised efficiency in financial market considering while loans to firms and individuals including consumer lending increased rapidly deposit of individuals didn’t go up. Productive investment in equipment and

3 Some observers say that the Mexican banks had been taken over by the ‘broker culture of the financial institutions which had bought them focusing on short-term gains through speculative position-taking. Banks and big firms in Mexico really did not realize danger of foreign borrowing and devaluation. machinery did not increase in spite of radical liberalization in financial sector and most financial resources led to unproductive one like acquisition of property.4 Rather, it was high risk and vulnerability of financial sector that financial liberalization brought in when domestic interest rate was still high and banks didn’t have enough capacity to monitor the borrowers. Meanwhile, there was extensive capital account deregulation to draw foreign capital in the 1990s. In 1990, the government allowed foreigners to buy government bonds and non-voting shares in almost all sectors of economy. Since then dollar-related peso- denominated government bond, Tesobonos was issued and bought by foreigners. This opening measures promoted a huge capital inflow, with most part of it being short-term portfolio investment and the Central Bank partly sterilized these inflows by issuing short- term peso debt, Cetes. Accordingly government debt including Cetes continued rather high and at the end of 1993 Cetes alone amounted to net international reserves. 5 Moreover, the government tried to roll over Cetes into Tesobonos recommending it to foreign and domestic investors, which was said to be a way to lower the risk related with currency rate volatility. Foreigners could change Cetes into Tesobonos in Mexico and in account of foreign banks as well. This policy combined with attractiveness of Tesobonos like high return and low risk led to rapid increase of Tesobonos, which was up to $18 billion at the end of 1994 from $1 billion at the beginning of 1994. But the rapid growth of Tesonobonos, short-term government dollar-related debt, could be very risky. It might trigger capital outflow when it was too much relative to foreign reserves and investors lose credibility in the Mexican economy. Massive capital outflow might lead to foreign reserves depletion and finally currency crisis and enforce the government to give up on pegged exchange rate system.

Table 3. Foreign capital flow in capital account of Mexico. (millions of dollars)

4 After 1990, lending to nontraded sectors like service and construction grew fast with manufacturing and agriculture lagging, of which commerce is conspicuous. Accordingly, these sectors accounted for most of the expenditure of fixed capital and tended to show faster growth. Moreover, most of the increased spending appears to be in construction and acquisition of property rather than machinery and equipment. (Danby, 1997) 5 This increase of foreign capital increased the ratio of M3 (M2+non-bank short-term securities) to GDP grew from 36% in 1989 to 41% in 1993. This situation is very dangerous and may generate a massive capital outflow with any rumor.(Sachs et al., 1996) 1991 1992 1993 1994-I 1994-II 1994- 1994- III IV Capital Account 24940 26542 30882 10768 73 3471 -3845 Borrowings 11450 3697 12859 5991 -225 -335 1992 Public 1534 -2438 1488 1263 320 505 306 Sector Banks 6052 1069 3980 2125 -379 -1414 665 Other 3864 5066 7390 2582 -167 574 1021 Private FDI 4761 4392 4900 1646 1620 2379 2132 Stock Market 6332 4783 10716 3465 247 743 -333 Money 3395 8116 6485 1486 35 1163 -4627 Market Gross -999 5551 -4079 -2022 -1603 -479 -3009 Outflows Reserves 8137 1173 6040 792 -9449 -127 Change -10102

Source : Banco de Mexico.

On top of this, it should be noticed that in the process of financial liberalization and capital account opening of Mexico, proper efforts to supervise financial institutions and manage short-term foreign capital flow were not established. (Edwards, 1999) The government overlooked the danger of financial liberalization under the strong neoliberal ideology and opening and failed in monitoring financial sector properly. In fact, the supervision system in Mexico was so underdeveloped because of the lack of personnel like inspectors and accountants and overlapping responsibilities among government institutions. The government did nothing about lending boom based on foreign capital inflow without solid and sound regulatory framework over banks. In sum, the financial opening after the 1990s in Mexico raised massive foreign short-term capital and the rapid foreign capital inflow was helpful to stabilize exchange rate and inflation in the early 90s to some extent. However, excessive dependence on foreign short-term debt with the absence of proper supervision system over financial sector made the economy very vulnerable. At the same time, the problem of current account deficit was getting worse because of overvaluation of peso. The pegged exchange rate with difference in inflation rate between dollar and peso, which was maintained by foreign capital inflow, generated effective overvaluation of peso. (Dornbush and Werner, 1994) It hit the export of Mexico so hard and cut in tariff and decrease of price of oil resulted in current account deficit. Most of all, increase in overall investment and decline in overall saving as well due to increase in private consumption especially related to foreign capital inflow contributed to this deficit in the early 1990s.6 In reality, the current account deficit amounted up to 6.8% of GDP in 1993 and almost 8% in 1994. This current account deficit mainly reflected an excessive private investment over private savings and gap between them, which grew after 1990. But in this situation, the government failed to adjust peso exchange rate and to address serious current account deficit problem because it was scared by the danger of inflation due to devaluation (Edwards, 1997). And it did not adopt increase in interest rate with the consideration of serious recession but just expanded domestic credit, which was wrong policy response.

2.3. Onset of Crisis

In spite of the problems, as of the early 1994 it was still hard to predict the currency crisis. So-called fundamentals like the government debt, level of foreign debt relative to GDP were not so as serious to lead to the crisis, even overvaluation of peso and large current deficit might have been addressed with proper policy response. What caused the crisis directly were several shocks to worsen foreign investors’ confidence in the Mexican economy and bad policy response of the government stimulated panic about the government and the whole Mexican economy. First, several incidents like Chiapas uprising in January and assassination of presidential candidate Colosio in March of 1994 brought out uncertainty about the Mexican economy. Besides, increase of interest rate in America in early 1994 also affected the foreign investors’ decision not to invest more in Mexico. Accordingly foreign investors stopped financing and foreign capital inflow fell very rapidly in 1994. Capital account surplus decreased from about 10 billion dollars in the first quarter to 10 million dollars in the second quarter of 1994 due to significant decrease in foreign borrowings and portfolio investment. The Mexican private sector tried to change security

6 The link was the banking system which converted increased liquidity from external sector into real estate and consumption loans (Sachs et al., 1996). selling to foreign investor to the central bank after March, which led to domestic credit expansion. Though risk premium of Mexican economy was increased, the government did not raise domestic interest rate, which was necessary to address serious current account deficit problem. The political consideration against recession before presidential election made the government hard to adopt depreciation and raise interest rate. Finally, under the pegged exchange rate system, the Mexicans funded maintained current account deficit with the pesos generated by the credit expansion and it led to precipitous fall of foreign reserve. Due to this bad policy response only to deplete foreign reserves, the possibility of financial panic in Mexico loomed in 1994. The short-term liability of the government and the banking system increased very high compared with the liquid reserves, which made the government financially vulnerable. Especially, the short-term foreign currency denominated debt soared in 1994 as the government rolled over Cetes into Tesobonos. By the end of September, the stock of Tesobonos reached the same amount of the reserves and government debt was 2.6 times reserves. This situation drove foreign investors into panic, making them believe the government will default on its liabilities. In the end, they stopped new lending to the government and there was mass foreign outflow from Mexico, with capital account deficit 3.8 billion in the fourth quarter. Finally the self- fulfilling panic engulfed Mexico in December due to depletion of reserves, too high dollar related short-term debt and international rating agencies’ downgrading. The illiquidity of the government made the whole Mexican economy cut off from international capital market. In fact, foreign capital outflow from Mexico amounted to 26 billion dollars from September of 1994 to January of 1995. On December 20, the government made an unexpected announcement of devaluation of peso by 15% breaking the commitment to keep the pegged exchange rate. It only worsened the foreign investors’ panic, who withdrew foreign capital from Mexico competitively, only to deplete reserves more and more.7 Finally the government abandoned floating band system and adopted free floating system but continuous foreign capital outflow under free floating led to devaluation of peso by more than 40%. After this currency crisis Mexico resorted to the IMF bailout

7 Foreign reserves in Mexico plummeted from 26billion dollars in March to 6billion dollars in December of 1994. program and got around 5.3 billion bail-out finance including the IMF, BIS, and the U.S. government. The Mexican peso crisis shows how inadequate policy response to shock could lead the economy to crisis and the government must make efforts to take proper policy change. It means that the role of the state to mange the national economy must be enhanced adjusted to the change of the world economy. Most of all, we should notice the deep cause of the crisis was rapid foreign capital inflow because of financial liberalization process in the 90s. When financial market globalization developed so much the mere financial liberalization and opening without proper supervision made financial vulnerability more serious.

3. Korea : debacle due to structural problems and underregulation

3.1. Dark Side of ‘Miracle’

Korea was one of the best developing countries in terms of rapid economic development, even called a ‘miracle’. Though major neoclassical view thought it was mostly due to free operation of the market, in reality the state in Korea intervened into the economy so heavily and effectively, which was a key to the economic success. (Amsden, 1989) The strong role of the state can be found in industrial policy, strong financial control and various trade protection etc. Most of all, the government control of finance was very strong, called ‘state-led financial system’, and a base of other economic policies. Since the 60s, the government made a great effort to mobilize financial resources and allocate them to priority sectors and firms with policy loans in line with industrial policy, sharing the risk of industrial sector with economic restructuring program. In this process there was specific government-business relationship that autonomous and capable government disciplined and supported big business based on financial control. This strategy was so successful in promoting private investment and economic growth, encouraging big business called ‘chaebol’. However, It was not free from problem. Actually strong state control over finance made financial sector very weak and banks have not had management autonomy and capability to monitor business with high nonperforming loans. Besides, corporate governance structure of business was so bad due to concentrated ownership structure and dependence on external debt was too high. Despite these problems, when the state maintained financial power and could discipline big business the structural problems were not that serious. But at the end of 1980s, the government financial control grew weaker with the growth of nonbank financial institutions uncontrolled by the government and change in composition of policy loan.8 While, the power of big business against the government got bigger and bigger along with economic development itself and they demanded strongly more and more financial liberalization and opening. However, their corporate governance structure was still so bad that bad investment decision could not be checked and monitored properly and very high debt ratio continued. The government failed in reformulating financial system in the 80’s and financial sector in Korea was still very weak with high non-performing loans in the 80s and 90s. Accordingly, in spite of disappearance of former discipline over business, a new system like monitoring over business by financial institutions did not appear. Bad management of chaebols like excessive investment and diversification got worsened based on high external debt.9 Even in this situation, the government adopted more deregulation policy for chaebols and in financial sector after 1993, which made these structural problems more serious. In this regard, the root of the crisis in Korea deeply originated in structural problems in industrial and financial sector, raised in the course of economic development. In particular, the change in financial system and government-business relationship and failure in real financial reform contributed to aggravate them. Thus, every macroeconomic fundamentals looked very good in Korea even just before the crisis but microeconomic fundamantals like profit rate of firms, overinvestment problem in

8 The share of banks in deposit and loan market continuously decreased with 81.7% and 77.4% in 1972, 74.5%, 64.8% in 1978, 56.3%, 57.9% in 1984, 40.5%, 49.7% in 1990, and the share of NBFIs (nonbank finnacial institutions) such as investment companies, insurance compaines, and security companies, less controlled by the government, increased. For policy loan, at the end of 80s, with huge current account surplus and growing demand of democratization the share to big business was reduced very much. (Lee, 1998) 9 It is related not only to bad corporate governance structure of them but also the end of the government investment coordination among them. After 1990 when the state-led investment reorganization program including several heavy and chemical industries was over , chaebols promoted their investment and tried to enter those industries competitively . (Chang, 1998) industrial sector, and soundness of financial sector were getting worse in the 90s. Financial opening in this situation was very dangerous because foreign capital could outflow in response to any shock due to these problems.

3.2. Financial Opening and Increase of Short-term Borrowings

The financial sector in Korea had been strongly controlled by the government during the development of the 60s and 70s. In the 80’s, after the serious recession in 79-80 due to over-capacity in heavy and chemical industry, the government promoted several financial liberalization measures like privatization of commercial banks, interest rate deregulation, and reduction of policy loans. But these measures were just formal and the government still tried to control financial sector to manage the economy using banks as a tool of economic policy (Lee, 1998). In particular, capital account opening was little developed and the government management over foreign capital maintained. Meanwhile, financial market structure itself and finance of business changed that government control over finance and business grew weaker around the late 80s. Extensive financial liberalization was realized after 1993 reflecting this changed situation like demand from chaebols. Also international pressure from the U.S. government and the decision to join the OECD affected this process. The financial liberalization in the 90’s covers so many areas including interest rate deregulation, deregulation of entry and business in financial industry, and foreign capital inflow. First, there was progress in interest rate deregulation.10 The new government declared to deregulate all lending rates, except policy loans, and many deposit rates, including long- term savings, corporate bonds, and CD (certificate of deposits) after 1993. However, different from the original plan, in practice short-term interest rates, such as CD and CP (commercial paper), dealt in mainly by the NBFI’s (Non Bank Financial Institutions), were first liberalized more rapidly, while lending and deposit rates in commercial banks were still under de facto control. It resulted in short-term financial transactions increase with higher risk and the NBFI’s bcame to be the main players. 10 In the 1980s, interest liberalization did not proceed well. One of the main reasons for this was the government’s consideration of increasing burden on private firms of increased interest rates. In contrast, in the 1990s interest deregulation went rather smoothly, compared to the 1980s. It is important to note that this was possible because chaebols are now less dependent upon bank loans than before. In the early 1990s, the government also introduced deregulation regarding new entry and ownership of financial institutions. It gave a new license for more merchant banks dealing in mainly foreign borrowings, 9 in 1994 and 16 in 1996. The original policy suggestions was known to be to merge small investment finance companies with existing merchant banks, but in reality, small investment financial companies just got license for merchant banks.11 Another important deregulation was significant loosening of restriction of chaebols’ ownership over several NBIF’s, such as life insurance companies, investment and trust companies. In 1996, all chaebols, except the top 5, were allowed to own and control life insurance companies and restriction to ownership of investment and trust companies was also abolished. These measures reflected chaebols’ power and strengthened their financial power more. As a matter fact, most NBFIs were owned by top 30 chaebols. For foreign capital inflow, the post-1993 financial opening in Korea should be regarded as the first comprehensive one. It includes deregulation in diverse dimensions, including issuance of foreign-currency denominated bonds by domestic firms and financial institutions, export-related foreign borrowing, and general commercial borrowing, and several measures for portfolio capital inflow. The government also abolished annual ceiling on foreign-currency loans by financial organization in 1993 and lowered long term borrowing requirement from 70% to 50%. In this opening program, it is very important to notice asymmetric nature of liberalization, namely effective deregulation of short-term transactions versus partial or no deregulation of long term transactions. While long-term commercial borrowing and issuance of long-term bonds, albeit deregulated, were still subject to volume restrictions, short-term borrowing had met no effective restriction or monitoring.12 Finally, this financial opening resulted in the spree of short-term foreign borrowings and rapid increase in short-term debt after 1994.

Table 4. Capital inflow into Korea in the 90s (0.1 billion dollars)

11 In this process, the compulsory qualification standards for new license were practically ignored, and it was alleged there was even bribery during the process. 12 This assymetric deregulation was related with the fact that government was concerned about the impact of inflow of long term capital on money supply and since roll-over had been customary, the government went easier with short term borrowing. (Lee et al., 1999) 92 93 94 95 96 97 Capital Inflow (1+2+3) 69.9 32.2 107.3 172.2 239.2 60.3 1. Direct Investment -4.3 -7.5 -16.5 -17.8 -23.4 -19.5 2. Portfolio Investment 58.0 100.1 61.2 115.9 151.8 147.6 3. Borrowings (A+B) 16.2 -60.5 62.6 74.6 110.8 -67.9 A. Assets -33.0 -45.9 -73.7 - 139.9 -134.9 -107.4 B. Debts 49.2 -14.6 136.3 214.5 245.7 39.5 Financial Institutions 24.3 12.0 89.8 134.0 141.5 -141.2 Borrowing Long-term 12.0 0.8 19.5 16.1 15.3 7.2 Banks 9.0 1.5 21.8 20.3 24.9 6.6 Development Institutions 0.8 -0.8 0.1 -3.5 -8.5 -0.1 Merchant Banks 2.2 0.1 -2.4 -0.7 -1.1 0.7 Short-term 12.3 11.2 70.3 117.9 126.2 -148.4 Banks 7.0 3.9 53.8 85.2 71.9 -103.1 Development Institutions 5.9 5.6 7.8 15.6 22.4 -24.3 Merchant Banks -0.6 1.7 8.7 17.1 31.9 -21.0 Firms Borrowings 24.9 -26.6 46.5 80.5 104.2 180.7

Source : Bank of Korea, International account table.

As seen in the table, major agents of foreign borrowing were financial institution and firms and as a result foreign debt in Korea soared, especially short-term one. But unfortunately the government regulatory system over financial institutions in Korea was never effective because the responsibility of supervision was not unified and thus monitoring structure was very complicated with many loop holes (Balino and Ubide, 1999).13 The problem was especially serious for merchant banks that didn’t have much experience in international transactions involving more risk. The supervisory agent did not have either capable manpower or know-how to supervise them, while usually there was cozy relationship between merchant banks and supervisory agent. Merchant banks were inclined toward short-term borrowing and the portfolio tended to be biased toward high yielding but riskier assets, thereby leading to the problem of term mismatch and higher market and liquidity risk.14 Besides, while the Korean financial sector expanded 13 Supervisory responsibility over foreign-exchange denominated businesses of banks were divided between the Ministry of Economy and Finance (MEF: a super ministry merging the former Economic Planning Board and the Ministry of Finance) and the Bank of Korea. The MEF took the part of foreign (long-term) capital inducement and outward foreign direct investment, whereas the Bank of Korea took the part of (short-term) foreign capital inflow and its impact on money supply. 14 Moreover, these chaebol-affiliated merchant banks concentrated their loans to chaebol-affiliated firms. It was possible since they were subject to less restriction to limit to loans that can given to the same persons (chaebols), with 150% of equity capital compared with 45% for banks. In consequence, as of March 1997, their business to foreign countries like establishing foreign subsidiaries and offshore funds, the monitoring over those internationalized financial business was also so bad. Most offshore funds of Korea faced serious deficit due to bad investment and foreign branches of firms and financial institutions continued to borrow short-term capital without government regulation. In spite of extensive financial liberalization and rapid increase of foreign short-tem debt, the proper regulatory system was never established, which made financial sector in Korea more vulnerable.

3.3. Crisis of 1997 : end of miracle?

Surely, the apparent cause of the Korean crisis in 1997 was rapid outflow of short-term foreign capital as a form of refusal to rollover, which flowed into Korea as a form of short-term foreign borrowings. After the rapid financial openings in 1993, foreign debts soared in Korea from $ 44 billion in 1992 to $ 120 billion at the end of 1997, with external liabilities including the offshore borrowings of the Korean banks amounting to $ 170 billion.

Table 5. : The growth of foreign debt by term in Korea ($ billion, %)

1990 1991 1992 1993 1994 1995 1996 1997 Total foreign debts 317 391 428 439 568 784 1045 1208 Short-term debts 143 172 185 192 304 453 608 513 Long-term debts 174 219 243 247 264 331 437 695 Ratio of short-term debts 45.1 44.0 43.2 43.7 53.5 57.8 58.2 42.4 Current accounts/GDP -0.9 -3.0 -1.5 0.1 -1.2 -2.0 -4.8 -3.9

Source : Bank of Korea, Bank of International Settlement.

Especially, there was rapid growth of dangerous short-term foreign debt due to the assymetric financial openging in favor of short-term borrowings. But this situation was

the share of loans given to the top 30 chaebols was as high as 51% of total lending of the merchant banks. In addition, while the maximum amount of domestic short term borrowing by the merchant banks were set to be 100 % ( or 300 % in some cases), there was no such limit on the foreign borrowing, quite strange asymmetry. (Lee et al., 1999) very vulnerable since there was serious term mismatch problem for especially merchant banks.15 Behind this problem in financial sector there was problem in industrial sector, bad management of chaebols. Despite very low rate of return, they promoted investment heavily and diversified continuously based on high external debt through NBFIs and at last went bankrupt in 1997, which was an internal shock to Korean economy. Their profit rate and capital productivity was very low due to bad and excessive investment after the late 80s.16 But they recklessly continued to expand their businesses after the 1990s mainly based on foreign high short-term debts through NBFIs. In particular, the problem of so- called over and cross investment was getting more and more serious in the major industries of Korea such as automobile, petrochemicals and steel.

Table 6. Trends in facility investment in Korea

1983-91 1992-3 1994 1995 1996 All industries 20.0 -1.0 36.7 37.9 17.3 Manufacturing 29.6 -8.9 56.2 43.5 17.1 The ‘six’ industries 20.3 -6.8 68.2 48.7 25.1 Non-manufacturing 10.1 15.5 9.5 26.9 17.7

Notes : The ‘six’ are petroleum refining, petrochemical, iron and steel, electrical and electronics, automobile and shipbuilding Source : Korea development bank, from Chang et al. (1998)

In addition, chaebols continued to diversify even in recession after the 1990s, increasing top 30 chaebols’ firms to 767 in 1997 from 616 in 1994. This bad management originated in the bad corporate governance of chaebols in which the decision of owner could not be checked or monitored in any way and the situation in which the government could not discipline chaebols any more. The change of financial system and relationship between the government and business with the failure of reform of chaebols and financial sector brought out these problems. Of course there was an overinvestment problem in the past,

15 They borrowed short-term foreign capital about 64% and lent long-term about 85%.(Chang, 1998) 16 In Korea, income/asset rate (ROA) fell continuously after the late 1980s in Korea because of the decrease of sales/assets (rate of assets turning) due to high and bad investment. Besides, the capital/output ratio went down seriously after the late 1980s to be responsible for a fall of the profit rate. (Jang, 1997; Baily and Zitzewitz, 1998) Chaebols’ profit rate was lower than the average of manufacturing sector and most of chaebols’ ROE is lower than the interest rate in reality. but the enlarged scale of economy relative to reduced government financial control and especially dependence on foreign debts led it to the financial and currency crisis. In 1997, there broke out several bankruptcies of major chaebols, with high debt ratio over 500% in average and the excessive diversification.17 Starting with Hanbo’s bankruptcy which was alleged to have a cozy relationship with the government in January, 9 of 30 biggest chaebols in Korea went bankrupt this year. The bankruptcies made the non-performing loan problem of the banks even more serious and the financial sector more vulnerable, which deteriorated confidence about Korean economy.18 In this dangerous situation, the government policy was not proper. For instance, it tried to make Kia, an insolvent car company, a public company and also made serious mistakes in foreign currency administration like a false announcement about foreign currency holdings only to aggravate foreign investors’ confidence. These events with the contagious effect of the Asian currency crisis led to refusal to rollover of foreign borrowings and at last currency crisis of Korea. Faced with serious shortage of foreign reserves less than 3 billion as of late November 1997, the Korean government finally had to ask for IMF emergency loan in December. It was not enough to stop the foreign exchange crisis, and the escalation of the crisis was stopped only after the promise by the advanced countries of 10 billion emergency loan in December 24, 1997. The Korean crisis certainly stemmed from underregulation of the financial liberalization process by the government ( Stiglitz, 1998) even if current neo classical view thinks that it is because of the excessive state intervention (Summers, 1998). But it should be noted that the crisis was deeply originated in structural problem in big business like bad corporate governance and failure in establishing effective monitoring mechanism over them. It makes us pay attention to the change in financial system and government- business relationship after the late 80’s.

4. Lessons of the Crisis

17 Some of several bankrupt chaebols’ debt-equity ratio was over 1000%, with Jinro’s 3081%, Halla’s 2065%, New core’s 1224%. Moreover, mutual repayment guarantee turned bankruptcy of one firm into the chain bankruptcy of whole firms in chaebols. 18 In September of 1997, all nonperforming loan of banks was estimated 28.2 trillion won, 6.2% of all bank loans, but according to U.S. criteria it amounted to about 15% of all bank loans. 4.1. Globalization, Financial Liberalization and Crisis

The Mexican crisis of 1994 is mostly related with bad government policy and more fundamentally failure of long neoliberal restructuring since 1982 and the Korean crisis of 1997 is due to careless financial opening with structural problems of big business and financial sector. Surely, there is difference between them because they were on different trajectory of economic development with different policies. Most of all, the character of the government in terms of autonomy and capability is so much different, which is related to power relationship of social classes and specific history. However, the crisis in Mexico and Korea has several points in common to give us precious policy lessons to prevent financial crisis and understand a proper role of the state in developing countries. First, both of crises present how dangerous the short-term movement of international capital is to national economy. In Mexico, rapid downturn of portfolio investment flow for any reason was most important cause of the crisis and rejection of rollover of short-term debt to long-term one was direct cause in Korea. Since the 1980s, short-term international capital to move rapidly all over the world grew so much and it has increased the instability of the world economy especially of the developing countries with weak financial sector. Second, in both of those crises, so-called macroeconomic fundamentals like inflation, government deficit, foreign debt to GDP etc. were not good indicator to predict financial crisis.19 The experience of Mexico and Korea presents the illiquidity of the economy due to foreign investors panic can lead to crisis, so that especially short-term debt relative to foreign reserves very important. Also, we should point out any change in confidence of foreign investors can devastate the economy. Of course, it is related with the danger of globalized financial market in which short-term capital movement is very rapid and volatile, harmful to the economy (Felix, 1997). The development of financial globalization itself was based on the financial liberalization and deregulation, which makes it necessary to examine financial liberalization process critically in those countries suffering from crisis.

19 In Mexico, though exchange rate devaluation and current account deficit got serious it was difficult to predict the crisis and the others were sound. Korea was so good in most indicators except high ratio of short-term debt, which makes hard to explain both of crises based on former currency crisis model. In this regard, the third and most important common point is that both of countries adopted financial liberalization, especially financial opening, before the crisis. The Mexican government took several capital account deregulation after 1990 which increased foreign short-term capital inflow very much. Also It rolled over peso denominated bond to dollar linked bond in 1994 to surge foreign short-term debt. This short-term portfolio investment could not be regulated and was so volatile in the response to shock, which made the Mexican economy more and more vulnerable. In Korea also, the government deregulated foreign borrowings of financial institutions and foreign portfolio investment. Though portfolio investment flow was less important in Korea, the government failed in monitoring foreign borrowings of financial institutions. Especially, asymmetric deregulation in favor of short-term foreign borrowing generated short-term foreign borrowings spree of financial institutions and big business. It should be noticed that in this process the both of governments failed in establishing proper monitoring or regulation over financial institutions and foreign capital flow. Both of countries’ financial liberalization process after the 1990’s led to increase in very dangerous short-term debt when international financial capital flow was quite unstable. They should have been much more careful about financial opening with proper and strong regulation and supervision system. In this regard, the role of the state in proper regulation in financial sector is getting more important to prevent crisis. In fact many argue that mere financial liberalization or opening will not lead to economic development, different from the current neoclassical argument.20 If it’s the case, countries must be very careful about financial liberalization and capital account opening and moreover they need to adopt more strong policies like Tobin tax (Arestis and Sawyer, 1998). But after the crisis, more far-reaching financial opening have been taken, which would increase instability in the economy. But the problem doesn’t end here. The fact is foreign capital was neither invested in productive sector nor the rate of return was good for both of countries. In Mexico, foreign capital inflow raised lending boom in the early 1990s but banking sector mostly allocate

20 In spite of the argument by major neoclassicals that financial liberalization and opening will lead to more efficient resource allocation and rapid economic growth, it is hard to find any evidence of this argument. (Rodrik, 1998; Eatwell, 1998) Actually, rapid economic development of East Asian countries were opposite to this argument. Rather, careless financial liberalization in developing countries tends to raise the possibility of financial instability and crisis. the capital into unproductive sector like property just increasing private consumption. In Korea, even if most foreign borrowings were invested in industrial sector by chaebols, it was such a irrational decision with the rate of return so low, so-called overinvestment. This experience means that the government should perform an important role to help allocate foreign capital inflow productively, with effort of investment coordination or proper monitoring over business and repression of speculation. Beyond the careful financial liberalization with proper regulatory system, the government should address the problem of domestic resource allocation mechanism and induce private sector to invest productively. Considering this, proper industrial policy like one implemented in Korea in the 60-70s or necessary reform in corporate governance and financial system was essential for developing countries, the concrete policy surely depends on the level of development and concrete situation in each country.

4.2. Politics of Crisis and Restructuring

Although it is important to understand the problem of financial liberalization based on neoliberalism raised the crisis, we should go far to probe deeper root of this policy, power relationship. In fact, no economic policies are determined and adopted in the vacuum of power relationship, always the economic policies reflect the relationship among the groups including the government, other social classes, and international capital. From this perspective, we can analyze the crisis more exactly and can think about future economy better.21 Indeed, financial liberalization and capital account opening in both of countries itself reflect the power relationship of the country. In Korea, it reflects the demand from chaebols that were keen on getting freedom in investment decision beyond the government regulation. It is true that the Korean government succeeded in disciplining big business based on so-called ‘state-led’ financial system, controlling most of financial

21 Edwards derives several lessons from the crisis in Mexico and East Asian countries, like the problem of rigid exchange rate system, current account deficit, danger of short-term international capital, importance of bank supervision, and transparency in financial operation. (Edwards, 1999) Though it makes sense in a way, this major view still ignores the important power relationship or politics behind the crisis. For example, even failure in adjustment of exchange rate cannot be understood without consideration of politics. resources and allocating them to priority sectors. But, at the end of 1980s, the growth of big business and especially decrease of government financial control gave chaebols advantage against the government because they didn’t need to rely on the government in finance. Accordingly the government-business power relationship changed fundamentally in favor of big business. In the 1990s, chaebols in Korea continuously requested the government to liberalize and open financial market much further to capitalize on cheap foreign capital, adopting the neoliberalist ideology.. Interestingly, this demand of neoliberal policies from big business was also a strategy against working class that was getting powerful then. They thought they could suppress workers’ power with market mechanism like flexible labor market though they failed to adopt it in the early 1997. Along with financial liberalization and opening, it was the very chaebols that borrowed short-term foreign capital so much through financial institutions. But their investment was mostly bad, which led some of them to go bankrupt in 1997 and finally the crisis. In addition, the pressure from developed countries like U.S.A. and international capital affected the financial liberalization and opening after 1993 to a considrable extent. The U.S. government pushed the Korean government to open financial market and take more liberalization measures to level the ground for the U.S. capital after huge current account surplus in the late 1980s of Korea.22 The Korean economy, which grew so fast and big, was a good market for the U.S. financial capital and the prospect of growth seemed still very good relative to other countries. Thus, the Korean government agreed with the U.S. government on far-reaching financial liberalization and capital account opening after 1993. Besides, with the decision to join the OECD, Korea must have implemented financial opening to meet the OECD condition. These pressures from domestic big business and international capital, with neoliberal trend and belief in the government itself, enforced the weakened government to promote financial liberalization and opening, which ended up with dismantling the former institution in Korea and the crisis. This change of power relationship behind the financial liberalization and crisis can be also found in Mexico. Financial liberalization in the 80’s under the del la Madrid government mostly benefited financial capitalist and high interest rate of Cetes gave them great profit who were a broker of it. After 1986 when Mexico decided to join the GATT

22 In reality the Korean government financial liberalization plan was based on the agreement with the U.S. government, ‘3-stage financial reform blueprint’ in 1992. (Dalla and Khatkhate, 1995) the government chose export promotion strategy and integration into the world economy. Behind this process, there was change in power relationship that power of nationalist and populist group got weaker and power of financial capitalist and export oriented capitalist increased.23 This change weakened the ministries to represent workers, farmers and domestic capitalist while it strengthened the central bank and economic plan ministry that support financial capitalist with strong neoliberalism. The Salinas government, in which neoliberal bureaucrats got very powerful, promoted the neoliberal restructuring more further adopting radical financial liberalization, privatization and deregulation. The ruling PRI (Partido Revolucionario Institucional) finally abandoned very long and traditional support for workers and farmers and the Mexican government cut itself from the populist tradition supporting domestic and international financial capitalist. Of course, in this process, we should point out there was also strong pressure from the U.S. government and international capital with the reduction of foreign debt in the 80s based on Brady Plan and several IMF loan. While the crisis and polices responsible for it were strongly related with this change of power relationship, the crisis as such also has brought more change. To our sadness, after the crisis it was the international capital behind the IMF that got more powerful, and in serious recession and unemployment workers got much weaker than before the crisis. After the crisis, both of the governments had little choice but to adopt the IMF restructuring program, aimed at further reduction of the state intervention. Even though the cause of crisis was this kind of policy, Mexico and Korea are now adopting more extensive financial opening and more market driven policies like deregulation, privatization of public firms and even labor market flexibilization.24

23 Different from Korea where the government led the economic development disciplining private capital, in Mexico the power of the government itself had been not that big. The economic policies in Mexico reflected the domestic power relationship between each group and international one including foreign capital. Accordingly, we should focus on the change in power relationship between the groups. Hogenboom expresses this change as ‘transnationalizing state’ (Hogenboom, 1997). However, Cypher understands financial deregulation, especially privatization of nationalized commercial banks, as crisis of state autonomy in Mexico, which was most important reason of the crisis (Cypher, 1996). 24 After the crisis, Mexico and Korea seem to have recovered very rapidly from the crisis in that growth rate in Mexico increased to 5.1% in 96 from –6.2% in 97 and that in Korea is expected up to over 7% in 99 from around –7% in 98. But this recovery in Mexico was mostly related to rapid increase of export to America which enjoyed great boom with the NAFTA, while structural problems and instability of the economy continued. Also in Korea, problems in big business like bad corporate governance maintained and more financial opening would instabilize the economy further in the future. The interest of domestic capital was in most part congruent with these policies because they also wanted to more and more neoliberal economic policy. For example, in Korea even if the government took some reform policy for chaebols and financial sector based on the IMF program, the biggest chaebols’ economic power got stronger after the crisis and they are now trying to dominate banks directly. On the other hand, workers’ power got seriously encroached due to labor market flexibilization adopted after the crisis and with the high unemployment rate after the crisis, the situation of Korean working class was worsened and the ratio of irregular employment like temporary and part time has increased very high. Also in Mexico, workers’ power decreased significantly and general welfare of working people aggravated so much. Actually, the further neoliberal restructuring policies the Mexican government promoted since the crisis brought serious social conflict. (Roman and Aregui, 1997) This reality would make it harder to organize effective resistance against this harsh restructuring and yet the worsening income distribution and serious social conflict could provide a new chance. It can encourage the effort to make the government choose alternative program including strong capital control over international short-term capital and radical reform of the economy in direction to increase participation and efficiency as well. For this, of course, the government should be first reformed to enhance democratic control by people and recover the effective capability to manage the whole economy.

5. Concluding Remarks

The crisis of the 90’s in Mexico and Korea mostly stemmed from those neoliberal policies, in particular financial liberalization and opening, adopted in those countries were essential cause for the crisis. When they had serious structural problems in their economy careless financial opening without proper regulation was really dangerous policy. It increased rapid foreign capital inflow into both of countries but the capital flew out more rapidly when there were several shocks. The globalized financial market since the 80s made the flow of short-term capital movement very volatile and the state of developing countries could not manage the foreign capital flow after financial opening, which led to financial and currency crisis. This experience of Mexico and Korea presents the state in developing countries must take a very important role to prevent the crisis and continue economic development, opposite to neoliberal theory. The government in developing countries should make a great effort to regulate financial sector very carefully before mere financial liberalization and opening. Besides, it should reform domestic institution continuously to tackle structural problems adjusted to the change in the economy, in the course of development. Financial opening to short-term foreign capital should be adopted lastly, after establishing sound financial system and addressing structural problems in the economy. What is needed is not neoliberal policies but rather strong and capable state to reformulate institutions and regulate financial sector, which itself must be under democratic control. Naïve belief in market just aggravates the problems because market never operates in vacuum of power relationship and well without any good institutions. Moreover, the international cooperation among countries is essential in order to regulate volatile short- term capital movement to stabilize the world economy. But any policies must be understood in terms of political economy around the policies, like interest of social groups and power relationship among them. As a matter of fact, financial liberalization and opening in Mexico and Korea had much to do with the change of domestic and international power relationship in favor of financial capitalist, big business, or international capital. In this regard, much further neoliberal restructuring policies adopted after the crisis in both of countries also reflected more weakened workers’ power and politics including resistance against current policies and interest of international capital will determine the direction of the restructuring.

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