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Macroeconomic policy response

The sudden depreciation of the Korean won wreaked havoc on businesses and banks and the Korean economy entered an unprecedented crisis. Initially, the government tightened monetary and fiscal policies to contract domestic demand, improve the current account balance, and stabilize the exchange rate. The corporate bond yield soared from 12 percent before the crisis to over 30 percent at the end of 1997. As a result, the exchange rate began to stabilize in the second quarter of 1998 and the current account turned into a large surplus in 1998 (Table 2-15).

The austerity policies, however, deepened the recession and generated public criticism of the IMF, which demanded the tightening as a condition for liquidity support. It is not easy to determine what would have happened with more accommodative policies; nonetheless, the tightening seems to have been indispensable to stabilizing the foreign exchange market. Faced with a massive withdrawal by foreign creditors, domestic financial institutions flocked to the foreign exchange market to buy foreign currencies with borrowed money. The Korean won would have been substantially weakened if their borrowing had not been curbed by high interest rates (Joon-kyung Kim and Dongchul Cho, 2003, p.379).

As the liquidity crisis subsided, the government switched into an expansionary mode.
The interest rate was lowered and the fiscal deficit was increased. Helped by strong export demand from advanced countries, output growth recovered rapidly, moving from -5.7percent in 1997 to 10.7 percent in 1998. The government also embarked on a thorough reform of the corporate, financial and public sectors, and the labor market. The loose monetary and fiscal policy facilitated microeconomic reforms by reducing macroeconomic risks.

The corporate sector reform had two objectives. The first was to restructure insolvent firms that could not repay their debts, and the second was to strengthen market discipline to prevent future crises.
First, the restructuring effort relied on two strategies. One was the swapping of business lines (so-called “big deals”) between the chaebol that was arranged and enforced by the government. The other was out-of-court debt settlements, known as “workout” programs, whereby afirm and its creditors negotiated rescheduling or restructuring with more flexibility than in formal proceedings. These were emergency measures to speed up the restructuring. They differed from the industrial rationalization of the 1980s in that the size of bad loans was far larger. The restructuring process was also made as open and transparent as possible by inviting foreign as well as domestic investors to buy insolvent firms.
Second, the structural reform of the corporate sector was based on“the five plus three principles.” In January 1998, president-elect Kim Dae-jung and the owners of the four largest chaebol agreed on (1) enhancing the transparency of corporate management, (2) eliminating cross-debt guarantees, (3) improving the capital structure considerably, (4) focusing on core lines of business and strengthening cooperation with SMEs, and (5) increasing the accountability of controlling shareholders and managers. In accordance with these five principles, consolidated financial statements became mandatory for the chaebol, international accounting standards were introduced, listed companies were required to appoint outside directors, auniform debt-equity ratio ceiling of 200 percent was set for all firms (to be met by the end of 1999), and the Commerce Act was revised to recognize as
de facto directors those who carried out adirector’s role without such title (e.g., controlling shareholders). In August 1999, three more principles were added; (1) improving the governance structure of the NBFIs, (2) restraining intra-group circular shareholdings within the chaebol and blocking unfair inside trading, and (3) prohibiting unlawful inheritance and gifts. The main objective was to stop the chaebol from exploiting NBFIs under their control to escape restructuring, and to discourage chaebol owners from handing over their controlling interest illegally to their descendants and relatives.

Among the five plus three principles, two-namely, enhancing corporate transparency and increasing the accountability of controlling shareholders and managers-were essential in strengthening market discipline. Others-eliminating cross debt guarantees, improving the capital structure, etc.-were temporary measures employed during the period when the market principle was not working properly. The lack of market discipline was manifested when Daewoo issued an enormous amount of corporate bonds (17 trillion won) between the end of 1997 and September 1998 on the assumption that the government would not let the five largest chaebol falter.
On top of “the five plus three” principles, additional efforts were made to dispel moral hazard, improve corporate governance, and intensify competitive pressures. To dispel moral hazard, a partial deposit insurance system and forward-looking criteria for non-performing loans were introduced, and insolvent firms were allowed to go bankrupt (as in the case of Daewoo in 1999), inflicting losses on shareholders, financial institutions and other concerned parties. To improve corporate governance, conditions on the exercise of shareholders’ rights were relaxed, the role of institutional investors was expanded, and M&As were deregulated, leading to the stronger position of shareholders vis-a-vis the management. Lastly, to intensify competitive pressure, regulations on FDI were eliminated almost completely, the import diversification system was discontinued, and the bankruptcy law was revised.
As in the corporate sector, financial sector reform had two objectives; on the one hand, normalizing the financial system as fast as possible through restructuring, and on the other, rebuilding afinancial safety net to prevent future crises.

First, to normalize the financial system, the government planned a speedy state-led restructuring of financial institutions. Those institutions capable of creating systemic risks (e.g., large banks) were reorganized with capital injections. To minimize moral hazard and to maintain market discipline, the incumbent management was removed, existing shares were retired, and employees were laid off. On the other hand, those posing little systemic risk (e.g., small banks and merchant banking corporations) were wound down.

Second, to rebuild the financial safety net, a consolidated regulatory agency with oversight on the banking, securities and insurance industries was created. In addition, prompt corrective action was introduced. The criteria for non-performing loans became much more stringent, and Korea Asset Management Corporation was established in 1999 to purchase and dispose of the impaired assets of financial institutions.

In May 1998, financial sector restructuring funds of 64 trillion won were raised in a first round of bond issues. The second round in December 2000 added 40 trillion won to the pool of funds available for the purchase of impaired assets, recapitalization, and repayment of deposits of viable financial institutions. In addition to bond issues, the government resorted to other funding sources such as international lenders, state property holdings and public funds to raise a total of 168.3 trillion won, which was equivalent to 35 percent of GDP in 1998.

In restructuring corporations and financial institutions, the large-scale layoff of redundant workers was inevitable. However, militant labor unions had traditionally been a fixture in these organizations and great difficulty was expected in implementing the necessary reform. To build public consensus on the reforms, the government set up the Tripartite Commission in January 1998, which consisted of representatives from government, employer groups and the two national labor federations.

The key issue was legalizing layoffs for managerial reasons. The Tripartite Commission arrived at an agreement and relevant laws were revised in February 1998. Employers could now lay off workers in case of “urgent managerial need,” including M&As. Restrictions on the use of temporary dispatched workers were also reduced. Workers, on the other hand, made gains on such issues as legalizing civil servants’ workplace associations (a weaker form of labor unions) and teachers’ unions, and allowing the political participation of labor unions, which the unions had demanded consistently since the early 1990s.

The reform, however, did not contribute much to enhancing labor market flexibility because layoffs and the use of dispatched workers were already quite common in most workplaces. But the reform had political significance in ending nationwide disputes that erupted at the turn of 1997 concerning layoffs and other industrial relations issues.
Furthermore, most of the basic rights of workers were restored with the reform. Excessive restrictions on collective dismissal were now mostly dismantled. 1)

The public sector also undertook far-reaching reforms to set an example for private sector restructuring. Central government ministries were reorganized, and anew body in charge of prudential regulation was created. A large-scale privatization program was prepared, mandating immediate privatization for five SOEs, 2) a phased-in privatization for six, 3) and internal restructuring or managerial improvement for fifteen. At the same time, employment in central and local governments and their agencies was reduced drastically.
Efforts were also made to redefine the role of government and improve its capability.
The Regulatory Reform Committee was installed in the Prime Minister’s Office to lead the government-wide initiative to reduce total regulations by half. Confusion about the proper goals of regulatory reform persisted, but an OECD indicator points to a substantial reduction in product market regulations between 1998 and 2003 (Conway, Janod and Nicoletti, 2005). In addition, some managerial positions were opened up to outsiders, a performance-based pay system was introduced, and e-government was actively promoted.
Service quality improvement was also emphasized.

Before the crisis, Korea had already equipped itself with a basic welfare system, consisting of a public assistance program-Livelihood Protection Program (1961)-and four social insurance programs-Industrial Accident Compensation Insurance (1964), National Health Insurance (1977), National Pension Scheme (1988), and the Employment Insurance System (1995). 4) Most of these programs, however, were limited in their coverage. For example, the unemployment benefits of the Employment Insurance System (EIS) covered only those firms with at least 30 workers, and not all of these establishments actually paid insurance premiums.

Unemployment skyrocketed from 2.6 percent in 1997 to 7.0 percent in 1998, and many people fell below the poverty line. In response, the government increased wage subsidies to firms that retained redundant workers and expanded vocational training for the unemployed within the framework of EIS. In March 1998, a public works program was introduced to create jobs directly with tax money. This program played a major role during the crisis in providing emergency support to the poor. Unemployed college graduates could also benefit from government-paid internships at private companies.

At the same time, the government made important changes to the EIS and the public assistance program. First, the coverage of EIS was extended rapidly in 1998 to firms with at least ten workers (January), to those with at least five workers (March), and eventually to those with one or more workers (October). 5)

Second, a new public assistance program, the National Basic Livelihood Security Program (NBLSP), replaced the existing one in 2000. The NBLSP stipulated the responsibility of government to guarantee minimum living standards for the whole population by providing benefits to households below the poverty line. It has been, however, criticized for discouraging participants to seek employment. 6)

Source : SaKong, Il and Koh, Youngsun, 2010. The Korean Economy Six Decades of Growth and Development. Seoul: Korea Development Institute.


1) But excessive restrictions on individual dismissals-e.g., prohibition of long-term employment of non-regular workers-remain and need to be addressed in the future.
2) Pohang Steel and Iron Corporation, Korea Heavy Industries and Construction Company Limited, Korea General Chemistry Corporation, Korea Technology Banking Corporation and National Textbook Corporation.
3) Korea Telecom Corporation, Korea Tobacco and Ginseng Corporation, Korea Electrical Power Corporation, Korea Gas Corporation, Daehan Oil Pipeline Corporation and Korea District Heating.
4) Employment Insurance provides funding for various active labor market policies in addition to unemployment benefits.
5) Still, only 10 percent of the unemployed could receive unemployment benefits in 1998 because the eligibility depended on a minimum period of contribution to the EIS.
6) The implicit tax rate facing NBLSP beneficiaries is 100 percent because their benefits decline by the same amount as their earnings increase. All types of benefits (health, housing, education, etc.) are given to those under the poverty line, but none at all to those above it. These features impart to the beneficiaries a strong incentive not to escape from poverty.


· Kim, Joon-kyung and Dongchul Cho“, Overcoming the Economic Crisis of 1997,”in Cases of KDI’s Policy Study: Reflections on the Last Thirty Years, Korea Development Institute, 2003, pp.361-391 (in Korean).
· Conway, Paul, Veronique Janod, and Giuseppe Nicoletti, “Product Market Regulation in OECD Countries: 1998 to 2003,”Economics Department Working Papers No. 419, OECD, 2005.

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