The Evolution of Korea's Development Paradigm: Old Legacies and Emerging Trends in the Post-Crisis Era

Lim, Phillip Wonhyuk Working Paper The Evolution of Korea's Development Paradigm: Old Legacies and Emerging Trends in the Post-Crisis Era ADBI Research Paper Series, No. 21 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Lim, Phillip Wonhyuk (2001) : The Evolution of Korea's Development Paradigm: Old Legacies and Emerging Trends in the Post-Crisis Era, ADBI Research Paper Series, No. 21, Asian Development Bank Institute (ADBI), Tokyo, https://hdl.handle.net/11540/4126 This Version is available at: https://hdl.handle.net/10419/111119 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/3.0/igo/ ADB INSTITUTE WORKING PAPER 21 The Evolution of Korea’s Development Paradigm: Old Legacies and Emerging Trends in the Post-Crisis Era Phillip Wonhyuk Lim July 2001 ADB INSTITUTE TOKYO ASIAN DEVELOPMENT BANK INSTITUTE ASIAN DEVELOPMENT BANK INSTITUTE Focusing on corporate governance and financial resource allocation mechanisms, this paper uses path dependence and comparative institutional analyses to trace the evolution of Korea’s development paradigm and to assess the extent of changes in the economy since the 1997 crisis. However, the transition from an established government-business risk partnership to a market-oriented paradigm has not proved easy. Although the government dealt with the nonperforming loans problem, the author contends that it has been less willing to take substantive measures to enable financial institutions to lead corporate restructuring based on market principles. As long as Korea continues to harbor structural problems in corporate governance and the allocation of financial resources, the investment efficiency of the economy is likely to suffer. Instead the reform program should concentrate on improving the autonomy of the financial sector and introducing private remedies to address the persistent problems of corporate governance. ADB Institute Working Paper Series No. 21 July 2001 The Evolution of Korea’s Development Paradigm: Old Legacies and Emerging Trends in the Post-Crisis Era Phillip Wonhyuk Lim II ADB I NSTITUTE W ORKING P APER 21 Additional copies of the paper are available free from the Asian Development Bank Institute, 8th Floor, Kasumigaseki Building, 3-2-5 Kasumigaseki, Chiyoda-ku, Tokyo 100-6008, Japan. Attention: Publications. Also online at www.adbi.org The Working Paper Series primarily disseminates selected work in progress to facilitate an exchange of ideas within the Institute's constituencies and the wider academic and policy communities. An objective of the series is to circulate primary findings promptly, regardless of the degree of finish. The findings, interpretations, and conclusions are the author's own and are not necessarily endorsed by the Asian Development Bank Institute. They should not be attributed to the Asian Development Bank, its Boards, or any of its member countries. They are published under the responsibility of the Dean of the ADB Institute. The Institute does not guarantee the accuracy or reasonableness of the contents herein and accepts no responsibility whatsoever for any consequences of its use. The term "country", as used in the context of the ADB, refers to a member of the ADB and does not imply any view on the part of the Institute as to sovereignty or independent status. Names of countries or economies mentioned in this series are chosen by the authors, in the exercise of their academic freedom, and the Institute is in no way responsible for such usage. Copyright © 2001 Asian Development Bank Institute. All rights reserved. Produced by ADBI Publishing. ABOUT THE AUTHOR Phillip Wonhyuk Lim is a research fellow at the Korea Development Institute, a policy-oriented economic research institute in Seoul. An economic historian by training, he obtained his Ph.D. degree from Stanford University in 1993 and lectured at the Korea Military Academy until 1996. At KDI, he conducts research on the modern economic history of Korea and provides policy recommendations on issues related to the chaebol and state-owned enterprises. III PREFACE The ADB Institute aims to explore the most appropriate development paradigms for Asia composed of well-balanced combinations of the roles of markets, institutions, and governments in the post-crisis period. Under this broad research project on development paradigms, the ADB Institute Working Paper Series will contribute to disseminating works-in-progress as a building block of the project and will invite comments and questions. I trust that this series will provoke constructive discussions among policymakers as well as researchers about where Asian economies should go from the last crisis and current recovery. Masaru Yoshitomi Dean ADB Institute IV ABSTRACT Focusing on corporate governance and financial resource allocation mechanisms under various regimes, this paper uses the concept of path dependence and comparative institutional analysis to trace the evolution of Korea’s development paradigm and to assess the extent of changes in the Korean economy since the 1997 economic crisis. In the early 1960’s, Korea addressed the policy challenges of economic development by essentially combining a state-led allocation of financial resources and an export market orientation. The government nationalized banks and restricted inward foreign direct investment while providing repayment guarantees to foreign financial institutions on loans extended to Korean firms, most of which lacked the standing in the international financial markets to raise capital on their own. Scrapping the import-substitution bias of the 1950’s, the government removed various market distortions that had made it difficult for firms to exploit profitable investment opportunities. Korea’s development paradigm, which centered on the idea of government-business risk partnership, proved an effective choice given the country’s resource endowment at the time. From the outset, the government sought to contain idiosyncratic moral hazard, but systemic risks began to build up as apparently successful firms kept borrowing to expand their business. When an economic slowdown threatened to topple heavily indebted firms in 1972, the government decided to bail out the debt-plagued corporate sector and imposed a debt moratorium on curb loans−without holding the incumbent managers and owners responsible for their previous business decisions. The ensuing heavy and chemical industry drive further weakened investment discipline as the government increasingly directed private firms to carry out targeted projects. Disturbed by the distortion of the government-business risk partnership, some technocrats began to advocate a transition to a more market-oriented paradigm as early as the end of the 1970’s. Although domestic and foreign pressure for liberalization and democratization did lead to the weakening of government control, institutional reforms required to improve corporate governance and financial resource allocation were not implemented. In fact, what might be called “de-control without de-protection” proceeded as family-based business groups known as the chaebol took advantage of liberalization and the government’s implicit guarantee against their bankruptcy. The 1997 crisis should be understood within this context. In the post-crisis era, changes in the risk profiles of economic activities, combined with the collapse of the authority hierarchy after the crisis, seem to be the primary drivers behind Korea’s evolving development paradigm. The transition from the old government-business risk partnership to a more market-oriented paradigm, however, has been difficult. Although the government has swiftly dealt with the massive nonperforming loans problem, it has been far less willing to take substantive measures designed to put financial institutions in a position to lead corporate restructuring based on market principles. As long as Korea continues to harbor structural problems in the areas of corporate governance and the allocation of financial resources, however, the investment efficiency of the economy is likely to suffer, making it extremely vulnerable to macroeconomic shocks. The reform program should focus on improving the autonomy of the financial sector and introducing private remedies to address the problem of corporate governance. V TABLE OF CONTENTS About the Author II Preface III Abstract IV Table of Contents V 1. Introduction 1 2. Basic Analytical Framework 3 (1) Development Paradigms 3 (2) Comparative Institutional Analysis 4 (3) Path Dependence 6 3. The Emergence of Korea’s Development Paradigm 6 (1) The Formation of the Government-Business Risk Partnership 6 (2) The Consolidation and Distortion of the Risk Partnership 11 4. The Road to Crisis 15 (1) The Dangers of De-Control without De-Protection 15 (2) The 1997 Crisis in Perspective 18 5. Alternative Scenarios in the Post-Crisis Era 21 (1) Foreigners Take Over: The “Foreign Dominance” Scenario 21 (2) Old Habits Die Hard: The “Government Intransigence” Scenario 21 (3) The Empire Strikes Back: The “Chaebol Resurgence” Scenario 22 (4) The New Economy Takes Off: The “Fundamental Reform” Scenario 22 6. Korea’s Post-Crisis Paradigm: Work in Progress 23 (1) Dramatic Changes in Individual Mentality and Behavior 23 (2) Institutional Reform: Accomplishments and Limitations 25 (3) Dashed Hopes and Remaining Challenges 27 Tables and Figures (in body of text) Table 1 Economic Trends Before and After the 1972 Emergency Decree 12 Table 2 Value Added of the Chaebol as a share of GDP 14 Table 3 Trends in Corporate Financing in Korea (Based on Flows) 16 VI Table 4 Market Share of Financial Institutions in Korea 17 Table 5 In-Group Ownership Share of the Top Chaebols 18 Figure 1 Korea’s Exports, Imports and Investment as share of GDP 10 Figure 2 Interest Rates and Inflation 13 Figure 3 Profitability and Opportunity Costs of Capital for Korean Manufacturing Firms 20 Figure 4 FDI Flows into Korea (Notification Basis) 25 Figure 5 The Internet Boom in Korea 29 References 31 1 The Evolution of Korea’s Development Paradigm: Old Legacies and Emerging Trends in the Post-Crisis Era Phillip Wonhyuk Lim 1. Introduction The economic crisis that swept through Asia in 1997-1998 shattered what had been accepted as the conventional wisdom on Asia’s “miracle economies,” and led to a serious reappraisal of their economic systems. In no other crisis-stricken country was this trend more pronounced than Korea. Widely regarded as a watershed in the evolution of Korea’s development paradigm, and not just as a one-time shock, the crisis cast into doubt the viability of the old system based on government-business alliances and the public management of private risks. The old system might have contributed to rapid capital accumulation and helped catapult Korea from one of the poorest countries in the world to the ranks of OECD countries in a little more than three decades; however, the crisis made it clear that this system, fraught as it was with the risks of moral hazard and outright corruption, could not be sustained in a new economic environment characterized by liberalization and democratization. Korea is now in search of a new development paradigm. With regard to the future of the Korean economy, a spectrum of views seems to exist, ranging between two extremes. Appalled by the enormous cost that the old system exacted, proponents of the Anglo-Saxon model are calling for a comprehensive program of liberalization in capital, labor, and product markets. In contrast, champions of the old Korean system are trying to preserve the status quo, appealing to nationalist sentiments and inflating public fears about potential job losses. These two extremes, which represent the imperative of the market and the weight of history, respectively, serve as useful reference points in discussing the evolution of Korea’s development paradigm. No coherent paradigm has yet to emerge in the post-crisis period, but it is certainly possible to lay out alternative scenarios for the future based on the emerging trends that are changing the Korean economy. It is the objective of this paper to trace the evolution of Korea’s development paradigm and to identify emerging features of the new system, using the concept of path dependence and comparative institutional analysis. The paper is organized as follows. Chapter 2 presents an overview of the major concepts and methodology used in the paper. A development paradigm is viewed as being shaped by the combination of the roles and functions of markets and non-market institutions as a nation responds to the developmental challenges of investment, conflict management, and engagement with the outside world. This paper employs comparative institutional analysis to highlight the distinguishing features of various development paradigms, and uses the concept of path dependence in a political economy context to demonstrate how “history matters” in their evolution. 8 member firms. Membership in these associations was mandatory. As for labor, all unions were disbanded following the 1961 coup, and the restructured Federation of Korean Trade Unions (FKTU) was forced to take a moderate stance. In just over one year, thus, the military government established various levers of control. Although the size of the state — as measured by the share of government spending in GNP — remained relatively small, its power was overwhelming. A question remained, however, as to what kind of state-led system Korea would have. The macroeconomic reforms launched in late 1962, at the insistence of the United States, ensured that Korea’s state-led development paradigm would not deviate significantly from a market-based one. Building upon the stabilization policies of 196364, the government devalued the Korean won from 130 to 255 to the dollar in May 1964. Also, in order to protect depositors from inflation and to encourage domestic savings, it raised the ceiling on the one-year time deposit rate from 15 percent to 30 percent on September 30, 1965 [C. Kim (1995: 114)]. These orthodox polices, which were designed to reduce distortions in macroeconomic variables, were accompanied by dirigist measures that deliberately introduced distortions into the microeconomic incentives. The Park government knew that Korea lacked the domestic resources to carry out its ambitious economic development program; however, unlike Latin American countries at the time (or Southeast Asian countries in the 1980s), it was not willing to depend on foreign direct investment (FDI). In a bid to tap into foreign capital while limiting the influence of foreign multinationals, the fiercely nationalistic government decided to rely heavily on foreign loans.7 However, as domestic firms lacked the standing to go to the international capital markets alone, the government decided to deal with the problem of lack of stature and asymmetric information and to allow state-owned banks to guarantee private-sector foreign borrowing. In adopting this measure, the Park government signaled that it was willing to form a risk partnership with business leaders. Although Park Chung Hee and his followers had initially condemned most of these businessmen as “illicit wealth accumulators,” they apparently concluded that a combination of state monitoring with private entrepreneurship would be the most effective means of carrying out its economic development plans. The alternative, of using state-owned enterprises to accelerate industrialization, as in the case of Taipei, China was not actively pursued. The government decided to use its credibility to raise capital on the international market and allocate financial resources to private firms, in effect contracting out the provision of goods and services to the private sector under a system of government monitoring and guarantees on loans. Through direct monitoring and market testing based on export performance, the government tried to contain the potential costs of moral hazard created by state-backed debt financing. Export performance, in particular, provided the government with a relatively objective criterion for selecting private firms when it made its decision on extending its repayment guarantees. 7 Cho and Kim (1997: 103) estimate that had investment been financed exclusively by domestic savings, the average economic growth rate during 1962-82 might have been only 4.9 percent per annum, well below the actual growth rate of 8.2 percent which was achieved with the injection of foreign capital. 9 In order to increase economic independence through export promotion, the government also introduced a number of export incentives. The short-term export credit system was streamlined as early as 1961. The essence of the new system was the automatic approval of loans by commercial banks to companies with an export letter of credit (L/C). In order to provide institutional support in the area of foreign marketing and technology imports, the government established the Korea Trade Promotion Corporation (KOTRA) in 1962, while an elaborate network of exporters’ associations provided more industry-specific services. A nearly 50-percent devaluation of the Korean won in 1964 gave a tremendous boost to exports, and a partial import liberalization, which was designed to allow Korean firms to purchase intermediate goods at world prices, gave an additional impetus. The government also gave exporters various tax deductions, generous wastage allowances, tariff exemptions, and concessional credits. In order to monitor export performance in reference to indicative targets set at the beginning of each year, the president himself chaired monthly export promotion meetings. Strong export performers were even given medals and national recognition on Export Day, which was established in 1964 to commemorate the day when Korea’s annual exports exceeded 100 million dollars for the first time. With an awareness of Korea’s comparative advantage in the 1960s, the government encouraged private firms to concentrate on labor-intensive industries.8 Korea’s development paradigm proved an efficient choice given Korea’s resource endowment at the time. In 1965, primary and secondary school enrollments in Korea were similar to rates in countries with three times its per capita income [World Bank (1993: 45-46)]. Cheap and high-quality labor could be readily employed to produce a high rate of return on investment in physical capital, as long as the country could tap into foreign capital and technology to compensate for the shortage of domestic resources and exploit its comparative advantage. The government’s decision to issue selective guarantees on the foreign borrowing of private firms and to promote exports was a solution to this developmental challenge. The government thus compensated for capital market imperfections and removed the constraints that had made it very difficult for firms to exploit profitable investment opportunities in the 1950s. 8 In 1962, labor-intensive manufactures accounted for less than 15 percent of Korea’s total exports of $54.8 million. In 1963, exports increased by $32 million (a 58.4% jump!) to reach $86.8 million, and labor-intensive manufactures such as textiles and footwear accounted for more than 80 percent of this increase. Overall, exports increased at an average annual rate of 35 percent in real terms from 1963 to 1969 [Yoo (1996: 8-9)]. 10 Figure 1 Korea’s Exports, Imports and Investment as Share of GDP 0 10 20 30 40 50 60 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Year Exports/GDP Imports/GDP Investment/GDP Source: Bank of Korea, National Accounts, various issues. Note: Investment here refers to gross fixed capital formation. Thus, what the Korean government did “right” in the take-off stage was of a different nature than is usually pointed out in the existing literature.9 The market failure that was effectively addressed by the government in the 1960s was due to the “imperfections in the international capital market” rather than coordination failures in the domestic manufacturing sector. Far more important for Korea’s economic growth, however, was the government’s effort to correct for the government failures of the past: policies designed to generate arbitrage opportunities that had made it virtually impossible for firms to exploit Korea’s comparative advantage in the 1950s. With the government addressing financing problems as well as macroeconomic imbalances, private firms could now invest and export to take advantage of unexplored profit opportunities. Rapid capital accumulation, combined with learning by exporting, was the key to Korea’s economic success. The country’s development paradigm was a popular choice in political economy terms as well. In this regard, it is important to note that if a nation has a comparative advantage in the labor-intensive sector, as Korea did in the 1960s, export orientation can 9 Most neoclassical perspectives typically trace Korea’s economic success to a set of market-oriented macroeconomic reforms carried out in 1964 and 1965 [Krueger (1979)]. But these measures by themselves would not have been very effective in correcting for the “imperfections (reluctance) in the international capital market” (i.e. it was basically impossible for little-known Korean firms to tap into foreign resources on their own, without government guarantees). Statist perspectives, by contrast, point to the pervasive distortion of government microeconomic incentives (“getting the prices wrong”), and argue that this corrective intervention promoted rapid economic growth [Amsden (1989)]. It is unclear, however, whether the Korean economy grew thanks to or in spite of government intervention. Although more sophisticated statist studies advance “coordination failure” arguments, they are less than convincing in showing the existence of essential, nontradable intermediate inputs in the “take-off” stage and demonstrating the role of the government in coordinating the production of these goods. 11 improve the welfare of workers. In addition, politicians, bureaucrats, and business leaders naturally favored the government-business risk partnership because it provided them with a large degree of control over resources. As a product of strong U.S. demands for macroeconomic stabilization, on the one hand, and a nationalistic Korean response designed to enhance economic independence, on the other, Korea’s development paradigm could thus secure wide support. (2) The Consolidation and Distortion of the Risk Partnership Korea’s development paradigm, which centered on the government-business risk partnership, encouraged rapid capital accumulation and produced spectacular economic growth. Reassured by government guarantees and subsequent economic growth, foreign financial institutions expanded loans to Korean firms and provided the lion’s share of the necessary capital for investment projects.10 Korean firms, for their part, dramatically increased their leverage while their profitability actually declined: the debtequity ratio of manufacturing firms, as measured by their total liabilities divided by net worth, rose from 92.7 percent in 1965 to 328.4 percent in 1970.11 While encouraging investment conducive to rapid economic growth, the Korean system thus led to a highly leveraged corporate sector that became extremely vulnerable to shocks. Although the Korean system was designed to minimize idiosyncratic moral hazard by making government support contingent on market performance, it was not prepared to deal with the increased systemic risks manifested by the higher leverage of most private firms. Firms that were apparently successful kept borrowing to expand their business, under government guarantees on foreign debt, and neither the government nor the private sector stopped to think seriously about the potential toll that a major economic downturn would take on the heavily indebted firms. When, in 1972, a serious economic slowdown following the investment explosion of the late 1960s threatened to topple the debt-plagued corporate sector, President Park decided to bail them out. He issued the Presidential Emergency Decree for Economic Stability and Growth, on August 3, 1972. This Decree placed an immediate moratorium on the payment of all corporate debts to curb lenders, and called for an extensive rescheduling of bank loans at a reduced interest rate. The moratorium was to last three years, after which all curb funds would have to be turned into five-year loans at a monthly interest rate of 1.35 percent, or an annual rate of 16.2 percent — at a time when the prevailing market rate exceeded 40 percent. The August 3 Emergency Decree forced “usurious” curb lenders and disorganized taxpayers to share losses, but left the owners and managers of firms and banks intact. Furthermore, no government officials took responsibility for the macroeconomic mismanagement of the late 1960s, and the 10 In the First and Second Five-Year Economic Development Plan periods (1962-71), foreign savings accounted for 52.8 percent and 39.4 percent of total investment, respectively. The share of foreign savings in investment remained significant through the 1970s, hovering around 20 percent. 11 During the same period, the net profit-to-net worth ratio of manufacturing firms declined from 15 percent to 11 percent. Normally, a firm with a high debt-equity ratio would be expected to have a high average return in order to compensate for the high risk of default. From 1970 to 1997, the debt-equity ratio of Korean manufacturing firms generally exceeded 300 percent while their profitability barely improved. 12 overheating of the economy that served as the background for the crisis of 1972. Violating the property rights of the creditors in the informal curb market, the government relieved the debt burden of the private firms it had come to rely on as agents to carry out its ambitious economic development plans. Table 1 Economic Trends Before and After the 1972 Emergency Decree (1964-1978) (Percent Per Annum, %) Growth Rate of Investment Rate of Inflation Interest Rate on Bank Loans Interest Rate on Curb Loans Total Liabilities/ Net Worth Net Profit/ Net Worth 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 13.3 19.3 84.0 25.2 52.3 45.1 11.3 24.9 3.7 40.7 30.2 24.9 77.1 43.1 45.1 30.0 5.8 14.6 15.9 16.1 15.5 15.5 12.5 16.7 13.6 30.5 25.2 21.3 16.6 22.8 16.5 18.5 26.0 26.0 25.8 24.5 24.0 23.0 17.7 15.5 15.5 15.5 16.1 15.0 17.1 61.80 58.92 58.68 56.52 56.04 51.36 50.16 46.44 39.00 33.24 40.56 47.88 40.47 38.07 41.70 100.5 92.7 117.7 151.2 201.3 270.0 328.4 394.2 313.4 272.7 316.0 339.5 364.6 350.7 366.8 15 15 17 17 16 14 11 4 17 30 23 17 22 21 23 Source: Bank of Korea, Economic Statistics Yearbook and Financial Statements Analysis, various issues; Cho, Je and Kim (1997). Note: The last two columns are the average figures for manufacturing firms (weighted by net worth). In retrospect, the August 3 Emergency Decree of 1972 was a turning point in the evolution of Korea’s development paradigm. It established the precedent for the government taking extraordinary measures to relieve financial distress when necessary — without holding the management of firms and banks accountable for their previous investment and lending decisions. Moreover, the Decree seemed to imply that an excessive dependence on debt would not only go unpunished but might actually be rewarded by the government — as long as other companies also depended heavily on debt. The Decree thus fundamentally changed the nature of state guarantees, and ushered in a new era characterized by the deepening of the government-business risk partnership. The ensuing Heavy and Chemical Industry (HCI) drive aggravated moral hazard as the government was increasingly trapped in a vicious cycle of intervention [Stern et al. (1995)]. During the late 1970s, HCIs accounted for almost 80 percent of all fixed investment in the manufacturing sector, though their share in manufacturing sector output was around 40 percent. The banks, as well as the newly established National Investment Fund, supported the HCI drive by providing policy-oriented loans at a negative real interest rate. As Figure 2 shows, this was a dramatic departure from the second half of the 1960s. As a result, the interest rate was no longer allowed to serve as a price signal, and serious macroeconomic imbalances ensued. 13 Figure 2 Interest Rates and Inflation Source: Bank of Korea, Economic Statistics Yearbook, various issues; KDI internal data. Note: The curb market rate is the interest rate applied to “Grade A ” firms. For the 1954-1995 period, the bank loan rate is the interest rate at the end of each year on general loans with a maturity of one year or less, for general enterprises. Effective July 1996, the monthly bank loan rate is calculated as the weighted average of the interest rates on new loans incurred in that month. The annual bank loan rate is equal to the December rate. In order to minimize time and exploit scale economies in establishing the capitalintensive HCI sector, the government relied on a select group of large conglomerates, providing them with extremely generous financial support. Known as chaebol, these family-based business groups drastically increased their share of GDP thanks primarily to the generous government support.12 During the heyday of the HCI drive, from 1974 to 1978, it was not uncommon for chaebol to triple their number of affiliates through new acquisitions in the heavy and chemical industries. 12 The chaebol, which literally means “a wealth clique,” could be defined as “a large business group that owes a significant portion of its growth to state support and is disproportionately controlled by a family with partial ownership.” Although the chaebol has become notorious for its large size and high degree of diversification into unrelated fields, these characteristics are primarily the consequences of the chaebol’s competitiveness as well as distortions in capital and product markets (due to state intervention in financial resource allocation and weak domestic competition). The essence of the chaebol has much more to do with its characteristic corporate governance (i.e. partial ownership but complete control by a family dynasty) and its political power, which influences the state in economic decisions. Given these defining features, the chaebol may behave more like a rule-setter than a rule-taker, and may have an objective function that diverges significantly from profit maximization for the firm as a whole. -10 0 10 20 30 40 50 60 70 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 Year curb market rate bank loan rate inflation rate(GNP deflator) 14 Table 2 Value Added of the Chaebol as a Share of GDP (%) 1973 1974 1975 1976 1977 1978 1979 1980 1981 Top 5 Top 10 Top 20 Top 46 3.5 5.1 7.1 9.8 3.8 5.6 7.8 10.3 4.7 7.1 9.8 12.3 5.1 7.2 9.4 12.3 8.2 10.6 13.3 16.3 8.1 10.9 14.0 17.1 - - - 16.6 - - - 19.5 - - - 24.0 Source: SaKong (1993). The HCI drive in the 1970s transformed the government-business risk partnership decidedly in favor of these family-based business groups. Unlike in the 1960s, international competitiveness (i.e., the “market test”) no longer operated as a selection criterion. The government simply believed in the entrepreneurship of a few chaebol founders and directed massive resources into their firms. Although Park Chung Hee might have felt that he could always control the chaebol like “quasi-SOEs,” he was in fact creating behemoths that would eventually come to dominate the Korean economy and change the government-business risk partnership in their own favor. Having channeled massive resources into the chaebol to carry out high-priority investment projects — sometimes over the initial objection of their owner-managers, the government had to take responsibility when the projects turned sour. Moreover, the gigantic size and high leverage of the chaebol strengthened the case for a “too big to fail” argument when crisis struck.13 In addition, a peculiar model of corporate expansion and restructuring seems to have been born in this period: (1) the chaebol relies on state-backed debt financing to undertake massive investment projects; (2) the going-concern value of the firm turns out to be greater than its liquidation value but less than its debt — i.e. the firm cannot really service its debt obligations; (3) the state steps in to write off a large portion of the debt and either sells the “clean” company to a different chaebol or preserves the ownership interests of the original firm; and (4) taxpayers wind up paying the bill. These developments in the 1970s had a profound impact on Korea’s development paradigm. In the 1960s, when the government was forging a risk partnership with private firms by guaranteeing the repayment of their foreign borrowing, it certainly did not intend to guarantee the governance rights of the incumbent owner-managers. The Emergency Decree of 1972 and the HCI drive, however, transformed the nature of the government-business risk partnership and exacerbated moral hazard. The installed base of business interests, with its high debt burden, pushed the government to move in this direction. Subsequently, the industrial targeting approach adopted during the HCI drive trapped the government in a vicious cycle of intervention, and the massive financial support extended to the top chaebol firms transformed the government-business risk partnership in favor of these family-based business groups. 13 The Daewoo experience in the 1970s provides an example. During the HCI drive, the Park government asked Daewoo, a textile and trading company, to take over a machine-tool manufacturer and a shipyard, as well as to enter the automobile industry. In the process of complying with the government’s wishes, Daewoo’s debt-equity ratio climbed to 900 percent. When Daewoo could not meet its debt obligations, the government had to bail it out. 15 4. The Road to Crisis (1) The Dangers of De-Control without De-Protection By the 1980s, it had become possible for successful Korean firms to raise capital internationally on their own. It had also become increasingly difficult for the government to identify profitable investment opportunities and monitor the performance of individual firms. Moreover, increased domestic and foreign pressure for liberalization and democratization was beginning to force the government to relinquish some of the important policy instruments it had used to motivate and discipline private firms. Given the reduced desirability and effectiveness of government intervention in the economy, policymakers should have fundamentally re-defined the role of the government. In fact, as early as the beginning of the 1980s, many technocrats had started to advocate a transition to a more market-oriented system. They were clearly aware of the dilemma faced by the government. Since the collapse of any large chaebol would bury the financial system in nonperforming loans, the government was more or less obliged to guarantee their stability. This implicit guarantee, however, encouraged the chaebol to undertake excessive investments. With the expectation that they would be bailed out should a crisis strike, they discounted the downside risks and invested wildly — unless restrained by the government. In order to maintain economic stability, the government thus found itself forced to intervene in the investment decisions of private firms. The technocrats believed that the only solution to this apparent dilemma would be for the government to let market forces operate and to allow nonviable chaebol to go bankrupt while containing the fallout from their collapse. The technocrats also thought that the government would have to hold the incumbent owner-managers accountable for their previous decisions and to refrain from intervening in the investment decisions of private firms in the future. Moreover, autonomous financial institutions, free from the control of the government and industrial capitalists, would have to be allowed to make decisions on their own and bear the full consequences of their actions. The government would have to re-define its role and focus on competition policy and prudential regulation rather than on allocating financial resources according to its industrial policy objectives. In other words, the government would have to stop providing direction and insurance to private firms, and limit its role to setting and enforcing “the rules of the game” and providing a social safety net. This series of decisive measures would serve as a credible signal that the regime had indeed changed. By this time, however, the Korean economic system had produced a coalition of economic players who were more interested in consolidating and maintaining the government-business risk partnership. Politicians and bureaucrats wanted to hold on to the levers of control, especially in the area of financial resource allocation. Business leaders wanted the government to continue providing loan guarantees and other support. Certainly, as evidenced by the experience of Taipei, China and Singapore, among others, the Korean economic system was not the only system that could produce rapid growth.14 Whenever reform-minded policymakers advocated a transition to a more 14 Note that Korea’s government-business risk partnership helped to create an economic system that was structurally vulnerable to cyclical shocks. Although Taipei,China and Singapore depend heavily on exports and are exposed to external shocks, they tend to deal with these shocks quite well. In contrast, 16 market-oriented system, however, the installed base of economic players with systemspecific interests blocked reforms. In the end, reform-minded policymakers were pushed aside by bureaucrats who were more willing to accommodate the wishes of the vested interests. In fact, while there were significant changes in Korea’s development paradigm from 1980 to 1997, these changes were not necessarily for the better. The country’s investment strategy began to rely increasingly more heavily on the private sector, but the institutional reforms required to improve corporate governance and the allocation of financial resources were not implemented. After Korea was democratized in 1987, its conflict management strategy had to be based on democratic processes, but needed measures to address campaign financing problems and corruption were not adopted, and the resolution of conflicts often involved protracted gridlocks (e.g., between labor and management) [Mo and Moon (1999)]. And Korea’s external strategy remained heavily geared to export markets and strongly discouraged inward foreign direct investment. Moreover, product and financial market liberalization was rather selective. Korea’s development paradigm during the Park era, in which the state provided both direction and insurance, or both control and protection, was becoming increasingly dysfunctional as what may be called de-control without de-protection proceeded. The old system of providing incentives and managing risks had broken down, and the problems of moral hazard and outright corruption grew as fundamental reforms were delayed. Table 3 Trends in Corporate Financing in Korea (Based on Flows) (%) 1970 1975 1980 1985 1988 1990 1991 1992 1993 Indirect finance 39.7 27.7 36 56.2 27.4 40.9 41.8 36.3 32.8 Borrowing from banks 30.2 19.1 20.8 35.4 19.4 16.8 19.8 15.1 13.7 Borrowing from NBFIs 9.5 8.6 15.2 20.8 8 24.1 22.0 21.1 19.0 Direct finance 15.1 26.1 22.9 30.3 59.5 45.2 37.9 41.4 53.3 Commercial papers 0.0 1.6 5.0 0.4 6.1 4 -3.8 7.6 14.7 Corporate bonds 1.1 1.1 6.1 16.1 7.5 23 24.2 12.5 15.0 Stocks 13.9 22.6 10.9 13 40.6 14.2 15.1 15.9 16.5 Foreign borrowings 29.6 29.8 16.6 0.8 6.4 6.8 4.4 5.0 -2.3 Others 15.6 16.4 24.5 12.7 6.7 7.1 15.9 17.3 16.2 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Bank of Korea (1994), Understanding the Flow of Funds in Korea; re-cited from Hahm (2000) Note: “Others” include government loans and trade credits among corporate firms The chaebol were no longer strictly controlled by the state, but implicit protection against their bankruptcy remained. The nature of this explosive combination was most evident in Korea’s investment strategy. Starting in the 1980s, the chaebol expanded their influence in the financial sector through the ownership of non-bank financial because of the high debt load carried by the Korean firms relative to their profitability, they tended to be much more vulnerable to external shocks. 17 institutions (NBFIs) such as merchant banks, security companies, investment trusts, and insurance companies. By offering a much higher rate of return than the banks, the NBFIs were able to attract a great deal of financial resources. Investors apparently believed that their investments in the NBFIs were protected by the government — just as safe as bank deposits. Tables 3 and 4 show how the flow of funds changed to strengthen the position of the chaebol. Partial financial liberalization, combined with the legacy of implicit government insurance, led to greatly increased overall risks in the financial system.15 Table 4 Market Share of Financial Institutions in Korea (End of period, %) 1980 1985 1990 1995 1998 Deposits Commercial Banks 42.8 31.2 25.5 19.9 22.6 Specialized Banks 28.1 22.4 15.5 7.9 5.2 NBFIs 29.1 46.4 59.0 72.2 72.2 Loans & Discounts Commercial Banks 38.8 34.2 29.3 23.9 27.9 Specialized Banks 24.5 24.2 19.0 12.6 10.0 NBFIs 36.7 41.6 51.7 63.5 62.1 Source: Hahm (2000) Problems in the corporate governance of private firms were no less serious than increased risks for inefficient investment due to the excessive supply of credit to the chaebol. Many chaebol-affiliated firms have gone public since the mid-1970s, and as Table 5 shows, the ownership share of the founder families has drastically fallen over time. As is well known from the corporate governance literature, this increasing separation of ownership and control has tended to aggravate the agency problem.16 When ownership and control are separated, it is important to devise an incentive and monitoring scheme to ensure that the managers work in the interests of the owners rather than their own.17 As the gap between ownership and control widened in chaebol15 With the benefit of hindsight, Koreans now appreciate (1) the importance of separating banking and commerce, (2) the problem of the implicit deposit insurance extended to NBFIs combined with asymmetric interest-rate deregulation, and (3) the need to develop autonomous financial institutions liberated from the control of the government and the chaebol. 16 In criticizing the chaebol, most casual observers, as well as some scholars, decry the concentration of ownership and control by the founder families. They typically argue that the separation of ownership and control will transform the chaebol into genuinely modern business corporations. Apparently, they have neither looked at the actual ownership data nor studied corporate governance issues. Their perception might have been shaped by the conduct of the chaebol groups before the 1980s, when they were closely owned and held. 17 In combination with Korea’s securities laws, that discouraged outsiders from accumulating voting rights, the general lack of transparency in accounting information acted as a barrier against mergers and 24 had preserved the interests of existing shareholders and managers. People began to accept the idea of privatizing risks and rewards. In addition to eroding the legitimacy of the existing hierarchy of authority, the collapse of the old paradigm based on the public management of private risks dramatically changed the risk profile of economic activities. The series of major bankruptcies seems to have had the desired effect of inducing firms, financial institutions, and investors to behave more cautiously, while the massive semi-forced retirements in the wake of the crisis seems to have led individuals to make efforts to improve their market value. As it became clear that the state would no longer bear private risks and protect existing shareholders, private firms began to realize the importance of risk management. Since the outbreak of the crisis, most firms have tried to improve their debt-equity ratios and cash flows by issuing new equity and selling assets. According to the Bank of Korea, the average debt-equity ratio for the Korean manufacturing sector declined from 396.3 percent in 1997 to 210.6 percent in 2000. The interest coverage ratio (operating profit / interest expenses) improved from 1.29 to 1.57 during the same period. The end of the “too big to fail” myth, together with intensifying global competition, began to force companies to exercise prudence in investment planning and to concentrate on developing core competencies. In the financial sector, the unprecedented closure of banks and NBFIs changed the attitudes of investors toward risk. Depositors came to understand that the government would not provide unconditional deposit insurance, and they began to check the soundness of bank balance sheets before making their deposits. The banks, for their part, reassessed the risks involved in lending to highly-leveraged firms and began to shift their business focus toward consumer loans. This shift raised a tantalizing prospect that the chaebol would have to improve their corporate governance and transparency in order to obtain more capital through direct financing channels. In the labor market, the end of the myth of lifetime employment also drastically changed the risk profile of job alternatives. As “stable” jobs in the public sector and at chaebol-affiliated firms turned out to be not so stable, the perceived risk gap between “stable” jobs and “unstable” jobs narrowed. As a result, workers became more willing to move from the “stable” to the “unstable” sector, making personal efforts to enhance their “market value” or mobility. For example, some of the best and the brightest among public servants moved to the private sector in the wake of the economic crisis, and many top-notch college graduates began to consider job choices other than chaebols. The IT revolution and the increasing tendency to value ability rather than seniority reinforced this trend. In this regard, it may be useful to note that the economic crisis also damaged the authority of the older generation. Traditional practices such as seniority-based wages no longer seemed tenable in an increasingly competitive environment, and it became increasingly difficult to justify authority based on something other than ability. 25 (2) Institutional Reform: Accomplishments and Limitations With the authority of the chaebol bosses greatly weakened by the crisis, president-elect Kim Dae-jung announced five principles of corporate restructuring in January 1998. These principles included: (1) enhancing transparency in corporate management; (2) eliminating cross debt guarantees; (3) improving financial structures; (4) improving corporate governance; and (5) streamlining business activities. Principles (1) and (4) were designed to address the problem of “arbitrary imperial rule” by the chaebol bosses, most of whom at the time, though not even legally registered as chief executives, exercised complete control over their firms. The intent of principles (2), (3), and (5) appeared to be to break up the “convoy-style” structure of the chaebol. In this early period, a series of policy measures designed to improve corporate governance and protect the property rights of minority shareholders was implemented. From 1998, all publicly listed firms were required to have at least one outside director, in order to promote the effective monitoring of management. Institutional investors were no longer required to follow a system of “shadow voting,” in which they had to cast their votes in proportion to other votes cast instead of exercising their full voting rights. Also, minimum shareholding requirements were significantly reduced for shareholders’ rights, such as the right to file derivative lawsuits against company executives for mismanagement, to request the dismissal of directors and internal auditors, to review accounting books, or to call for a general shareholders’ meeting [Park (2001)]. Non-governmental organizations (NGOs), such as People’s Solidarity for Participatory Democracy, led a campaign to introduce reforms designed to improve corporate governance. Source: Ministry of Commerce, Industry and Energy (unit: mil. US$) 0 2000 4000 6000 8000 10000 12000 14000 16000 18000 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Figure 4 FDI Flows into Korea (Notification Basis) 26 In addition to institutional reforms designed to improve corporate governance, the government introduced major changes to the FDI regime. The government enacted the Foreign Exchange Transaction Act in April 1999 to liberalize foreign exchange control. It also completely eliminated the ceiling on foreign equity ownership in the stock market as of May 1998. In the same month, the requirement that foreigners needed to obtain board approval for ownership of more than one-third of the outstanding shares of a firm was removed. Moreover, the government fully liberalized foreign land ownership by amending the Foreigner’s Land Acquisition Act in 1998.20 In November 1998, the Foreign Investment Promotion Act was enacted to replace the Act on Foreign Direct Investment and Foreign Capital Inducement. The new legislation focused on creating an investor-friendly environment by streamlining foreign investment procedures, strengthening investment incentives, and establishing an institutional framework for investor relationship management, such as the “one-stop service.” The government also scrapped its import diversification policy in 1999, which had been used since 1978 to block the inflow of Japanese consumer imports (justified on the ground of Korea’s large bilateral trade deficit with Japan). Although this measure was not directly connected with changes in the FDI regime, it reinforced the impression that the government was serious about fundamentally reorienting its external strategy. Compared with these positive institutional reforms in Korea’s FDI regime, which have resulted in a dramatic increase in FDI inflows (see Figure 4), progress in corporate restructuring has been rather slow. Out of concern over charges of revived interventionism as well as possible litigation a few years down the line, the bureaucrats minimized their involvement in corporate restructuring in the immediate post-crisis period. Instead, they opted for “bank-led corporate restructuring”— an oxymoron in view of the fact that the commercial banks in Korea were controlled by the government and were in no position to lead. As they had done before the crisis, the bankers looked to the government for guidance on how to deal with distressed firms. More often than not, “bankruptcy suspension” was the result, as the banks rescheduled just enough debt to keep the firms going and the government, which was the controlling shareholder of these banks, provided little guidance. A number of so-called “workout” firms were allowed to prolong their lives in a state of limbo.21 Although the government did introduce policy measures (e.g., a tighter forwardlooking criteria [FLC] for asset classification and provisioning) to encourage the banks to take decisive actions against financially distressed firms, the speed of implementation left something to be desired. As the controlling shareholder in the nationalized banks, the government should have taken more proactive measures to facilitate corporate restructuring while quickly implementing reforms designed to enhance market discipline. Instead, it has tended to be quite reluctant to intervene to facilitate the orderly exit of nonviable firms, though has been far less hesitant to step in to prop up questionable firms in the name of stabilizing the financial system. Increasingly, it has tended to put off the day of reckoning for distressed companies and nudge creditors to 20 In the words of Pietro Doran, a real estate dealer, Korea went from one of the most closed real estate markets in the world (including PRC) to one of the most liberal. 21 To the government’s credit, it did allow the Daewoo Group to go bankrupt in 1999 after vainly trying to come up with a solution that would have had a smaller adverse impact on the financial system. 27 opt for bankruptcy suspension, in the hope that the companies themselves might take care of their problems through self-rescue programs. In many ways, this represents the safest course of action for bureaucrats: intervening just enough to avert an immediate catastrophe but keeping their hands off so as not to invite charges of “killing off valuable firms” or “granting unjustifiable favors to the well-connected.” The restructuring of the financial sector was compromised by similar problems. Because of past mistakes involving weak prudential regulation and arbitrary intervention, the government was less than strict in applying the principle of accountability to investors who had made their decisions under past regimes. Concerns about systemic risks also played a part. In fact, the resolution of the Daewoo crisis in 1999 was delayed due to these concerns. In the end, the government decided to err on the “safe” side, and used taxpayers’ money to bail out individual investors rather generously, allowing them to redeem up to 95 percent of the face value of Daewoo corporate bonds. Many critics argued that the government carried the “path dependence” logic too far and failed to take advantage of a golden opportunity to address the problem of moral hazard and to establish the principle of accountability.22 As a result, after the end of the promising start in the early phase of reform, corporateand financial-sector restructuring in Korea was primarily driven by liquidity injection.23 In combination with a V-shaped recovery in 1999, the National Assembly elections in April 2000 slowed the momentum for fundamental reform. The government became increasingly reluctant to close nonviable firms and financial institutions. Bank privatization and the separation of banking and commerce were not even seriously considered. (3) Dashed Hopes and Remaining Challenges Since the outbreak of the economic crisis, Korea’s development paradigm has been affected by a confluence of changes in institutions as well as changes in people’s expectations. Although it is too early to draw a definitive conclusion on the new development paradigm, it is becoming increasingly clear which of the four alternative scenarios discussed in the previous chapter is more likely to unfold. The V-shaped recovery in 1999 all but extinguished popular fears about complete foreign dominance. Freed from the fear of having to sell assets to foreigners to pay off debt, some Koreans began to express nationalistic sentiments. During the National 22 Nevertheless, it must be acknowledged that imposing even a 5-percent loss rate on investors represented a dramatic departure from the past. In the pre-crisis period, financial institutions had made easy money by “guaranteeing” more than 90 percent of all outstanding corporate bonds, with an implicit understanding that the government would come to their rescue in time of crisis. Unnerved by the Daewoo fiasco, investors became aware of default risks, and interest rates on corporate bonds began to reflect risk differentials. Prior to the economic crisis of 1997, no meaningful rate spread existed in Korea’s corporate bond market. 23 In order to clean up nonperforming loans and maintain a functioning financial system, a total of 109.6 trillion won, the equivalent to almost one-fourth of Korea’s GDP, was injected in the first round of financial-sector restructuring. Almost two-thirds of this amount was used to rehabilitate the banking system, with the remainder spent in the non-bank financial sector. The second-stage plan envisages outlays of 50 trillion won, of which 10 trillion won would be recycled money and 40 trillion won additional public money. 28 Assembly election campaign in the spring of 2000, some even argued that selling assets to foreigners would amount to “a drain of national wealth.” The revival of these old attitudes toward foreign investment has been limited in scope, however. Most Koreans now accept increased foreign presence as a fact of life. For instance, the share of foreign investors in the market capitalization of companies listed on the Korea Stock Exchange increased from 14.6 percent in 1997 to 30.1 percent in 2000, and most Korean investors view this as a positive development. Those foreign companies that have managed to establish a foothold in Korea have also generally received positive publicity. Companies such as Volvo and Clark are using their Korean operations as production bases for the potentially lucrative PRC market, and their management techniques are portrayed in a favorable light. Volvo Korea, in particular, was put in the spotlight when its chief executive was promoted on the grounds of his success in Korea. In the financial sector, the Korea First (Cheil) Bank, which was taken over by the New Bridge Capital, has appointed a foreign CEO, and completely changed its way of doing business, focusing mainly on retail banking. The Korea First Bank has also been at the forefront of rejecting interventionist measures by the government. Through equity participation, a number of foreign financial institutions are also exerting a great deal of influence on the way Korean banks provide credit.24 Although nationalistic sentiments continue to be expressed, Koreans are gradually coming to appreciate the potential benefits of foreign direct investment. In the case of Daewoo Motors, for example, in the second half of 1999 there was a heated debate on the wisdom of selling it to a foreign company, such as Ford or GM. A series of successful FDI cases, including Renault’s takeover of Samsung Motors in early 2000, however, led the public to change their views on foreign companies. People are now clearly less persuaded by arguments in favor of injecting massive resources into financially distressed companies and transforming them into state-owned enterprises for industrial policy reasons. On the whole, the weaker version of the “foreign dominance” scenario — which may be called the “foreign presence” scenario — has become acceptable in Korea. Against the background of the V-shaped recovery in 1999, the “government intransigence” and “chaebol resurgence” scenarios seem to have become very likely possibilities. While institutional reforms in corporate governance and financial resource allocation were certainly less than adequate to address fundamental problems, the government engineered a remarkable turnaround in economic performance with its liquidity-driven restructuring program. With the assistance of favorable external conditions, Korea’s GDP growth rate soared from minus 6.7 percent in 1998 to a positive rate of 10.9 percent in 1999. The surviving chaebol-affiliated firms, for their part, could proudly point to greatly increased profits. Critics warning of the remaining problems in the economy were dismissed as Cassandras — as if a little more than a year of reform could have managed to remove all structural problems. The government and the chaebol continued to control the lion’s share of financial institutions. Although President Kim Dae-jung mentioned the need for a separation of banking and commerce in his speech of August 15, 1999, no concrete actions were taken. Nor was any program 24 For instance, as of end-2000, Goldman Sachs had a 11.1-percent equity stake in Citizens (Kookmin) Bank; the Bank of New York and ING group respectively had 13.1 percent and 10.0 percent of the Housing and Commerce Bank. 29 formulated to facilitate the privatization of the banks. In the area of corporate governance reform, the mandated increase in the number of outside directors did little to change the established practices of the chaebol. The V-shaped recovery reduced the perceived need for fundamental reform. People increasingly began to talk about a narrower version of the “New Economy” scenario, focusing exclusively on the IT revolution and overlooking the importance of effective deregulation and stable macroeconomic policy. There was a great increase in the number of venture firms and an explosion of Internet-related businesses, thanks in part to government support. The number of venture firms nearly quadrupled from 1,514 in September 1998 to 6,004 in March 2000. As shown by Figure 5, Korea’s internet revolution was truly impressive. Buoyed by a stock market boom, venture firms even began to attract talented workers away from the chaebol. These venture firms seemed to offer an alternative to the chaebol as many of them operated on principles closer to the Anglo-Saxon model. From the start, it seemed unlikely that these start-ups would completely replace the industrial giants, but the chaebol found themselves having to respond to the important changes introduced by these start-ups. For instance, they increasingly began to offer employee stock option plans and other incentives to retain talented people and induce them to make firm-specific human capital investments. It was hoped that these changes would lead to enhanced transparency in corporate governance and increased differentiation according to ability, thus reducing the structural problems. Figure 5 The Internet Boom in Korea 0 100,000 200,000 300,000 400,000 500,000 600,000 1994 1995 1996 1997 1998 1999 2000 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 (Thousand) Hosts Internet users Domain Source: Re-cited from Sung (2001), p.126. Number of Hosts / Domains (LHS) Number of Internet Users (RHS) 30 These high hopes were, however, all but dashed by the middle of 2000. Under the effect of deteriorating external conditions, the Korean economy began to slow down. In particular, rising crude oil prices and falling semiconductor prices worsened its terms of trade. In addition, the bankruptcy of the huge Daewoo Group in 1999 greatly increased nonperforming loans in the financial system. Due to political considerations in an election year, however, the government was slow to make requests for additional public funds. There was also a sense that the initial batch of public funds, which exceeded 100 trillion won, had been injected according to bureaucratic discretion rather than a welldefined set of rules. Under the burden of nonperforming loans, financial institutions began to reduce their supply of credit. Moreover, the Saehan Group’s abrupt filing for workout proceedings in May revived concerns about the reliability of credit ratings, as the company had been consistently rated investment-grade. It once again highlighted the need to enhance the transparency of corporate management and accounting. In addition, the Saehan case raised uncertainty about the viability of medium-sized chaebol, and resulted in a flight to quality in the financial market. The credit crunch was aggravated by the continued existence of nonviable workout firms, which “sucked in” precious resources at the expense of their competitors. Both the bureaucrats and the nationalized banks had incentives to stick to this forbearance policy instead of adopting structural measures such as privatization which would make bank-led corporate restructuring more credible. On top of these reminders of the incomplete nature of the reform in the financial sector, the feudalistic infighting for corporate control at the Hyundai Group illustrated that Korean firms had changed very little with regard to corporate governance. At times, even the government seemed to disregard the basic principles of corporate governance and encourage the founder families to revert to their old ways, urging profitable companies to come to the rescue of their “brother” companies in distress.25 In short, as long as Korea continues to harbor structural problems in the areas of corporate governance and the allocation of financial resource, the investment efficiency of the economy is likely to suffer, making it extremely vulnerable to external shocks. Unlike in the early stages of economic development, Korea no longer has an abundance of unexplored profit opportunities. It needs to allow a broad base of project evaluation experts to develop. In particular, the reform program should focus on improving the autonomy of the financial sector and introducing private remedies such as class action suits to address the problem of corporate governance. Only then will Korea be able to realistically dream about having a New Economy of its own. 25 For the Hyundai case, there is an interesting anecdote that is quite symbolic of what kind of change is taking place in the corporate governance of Korean firms. In the late autumn of 2000, it was rumored that the government was urging profitable Hyundai affiliates to provide assistance to Hyundai Engineering & Construction and other affiliates in financial distress. 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