Overview of the Financial Development

l  financial development before the takeoff

l  Industrial banking system(1961-79)

–      Financial institution reform with export promotion

–      1965 interest rate reform

–      Heavy and chemical industrialization(1972-79)

l  Finance Liberalization(1980-97)

Role of finance in Korea's rapid growth

l  Savings, investment, and growth

l  Role of foreign aids in the 1950's

l  Targeting investment and industrial banking system

l  Savings behavior

l  East Asian anomalies

Five-Year Economic Development Plan: Targeting Investment

l  First Plan(1962-66) : Development of basic industries for import substitution and expansion of SOC's

l  Second Plan (1967-71) : Development of labor-intensive manufacturing

l  Heavy and chemical industrialization from the Third Plan(1972-76) into the Fourth Plan(1977-81)

 n  Interest Rate Reform in 1965

Significance of the Reform

l  On September 30, 1965, deposit rates were doubled.

l  Intended to cure financial repression

l  Government was reluctant to raise loan rates and favored controlling monetary expansion.

Background of the Reform

l  The problem of financial repression: Significantly negative real interest rates on deposits divert funds to the unregulated money market.

l  The US Aid Program requested the reform.

l  The Gurley, Patrick, and Shaw report completed in July, 1965.

Reform Impact

l  Drastic increase in time deposits( 1-year time deposit rate doubled from 15% to 30%).

l  Increase in foreign borrowing.

l  Noticeable declines in curb market rates and curb market size are not observed.

l  Double digit growth and stable inflation.

Assessment of the Reform

l  Problems:

–      Lending rates rose less than deposit rates and operating balance of banks deteriorated.

–      Substantial increase in reserve requirement ratio and introduction of marginal reserve requirement system in 1966.

l  High growth and stable inflation are attributable o not only interest rate reform but also other measures.

–      Preferential export loans expanded.

–      Exchange rate devaluation in 1964.

–      Diplomatic relations with Japan normalized in 1965.

–      Export-oriented industrialization started with the implementation of the Second Five-Year Plan (1967-71).

 n  Korean Finance in the 19970's

The Presidential Decree of August 3, 1972

l  Large-scale adjustment of curb market borrowing

l  Replacement of short-term curb market borrowing with long-term borrowing form the Central Bank

l  Strengthening of credit guarantees to firms

l  Industrial rationalization plan

l  Downward adjustment of interest rates

n  Financial Liberalization and Financial Crisis

l  Financial liberalization began in the early 1980's

l  It has been gradual and cautious in sequencing.

l  But Korea encountered financial crisis in 1997.

l  Big Bang post-crisis liberalization

Financial Liberalization and Investment Boom

l  Pick up of Investment in 1994-95

l  Excessive short-term foreign borrowing and mismatch of assets and liabilities, short-term and long-term

l  Debt overburden surfaced in 1997 with the collapse of Hanbo Steel.

Fragile Financial Sector and Lax Supervision

l  Large corporations' insolvency deteriorated solvency of financial institutions.

l  Non-performing loans of commercial banks and merchant banks tripled in 1997.

l  Lack of transparency and lax supervision

–      Profitability of conglomerates overstated by inside transactions, cross payment guarantees, and non-performing loans of banks understated.

l  Prevalent moral hazards, weal profit-maximizing motives

Exchange Rate Policy and Contagion

l  The plunge of the Thai Baht in July 1997 quickly spread into neighboring countries.

l  Korean won under attack and capital flight in stock and bond market began.