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The Perversion of the Financial Liberalization/Globalization

Process: Chaebols and the South Korean Crisis

Although there are similarities with the perversion of the financial liberalization/globalization process that occurred in many emerging market economies, South Korea exhibited some particularly extraordinary elements because of the unique role of the chaebols, large, family-owned conglomerates. Because of their massive sizesales of the top five chaebols werenearly 50% of GDP right before the crisisthe chaebols were politically very powerful.

The chaebols' influence extended the government safety net far beyond the financial system because the government had a long-standing policy of viewing the chaebols as being "too big to fail." With this policy in place, the chaebols would receive direct government assistance or directed credit if they got into trouble. Not surprisingly, given this guarantee, chaebols borrowed like crazy and were highly leveraged. In the 1990s, the chaebols were in trouble: they weren't making any money. From 1993 to 1996, the return on assets for the top 30 chaebols was never much more than 3% (a comparable figure for U.S. corporations is 15-20%). In 1996 right before the crisis hit, the rate of return on assets had fallen to 0.2%. Furthermore, only the top 5 chaebols had any profits: the 6th to 30th chaebols never had a rate of return on assets much above 1% and in many years had negative rates of returns. With this poor profitability and the already high leverage, any banker would pull back on lending to these conglomerates if there were no government safety net. Because the banks knew the government would make good on the chaebol's loans if they were in default, the opposite occurred: banks continued to lend to the chaebols, evergreened their loans, and, in effect, threw good money after bad. Even though the chaebols were getting substantial financing from commercial banks, it was not enough to feed their insatiable appetite for more credit. The chaebols decided that the way out of their troubles was to pursue growth, and they needed massive amounts of funds to do it. Even with the vaunted Korean national savings rate of over 30%, there just were not enough loanable funds to finance the chaebols' planned expansion. Where could they get it? The answer was in the international capital markets. The chaebols encouraged the Korean government to accelerate the process of opening up Korean financial markets to foreign capital as part of the liberalization process. In 1993, the government expanded the ability of domestic banks to make the loans denominated in foreign currency by expanding the types of loans for which this was possible. At the same time, the Korean government effectively allowed unlimited short-term foreign borrowing by financial institutions, but maintained quantity restrictions on long-term borrowing as a means of managing capital flows into the country.

Opening up short term but not long term to foreign capital flows made no economic sense. It is

short-term capital flows that make an emerging market economy financially fragile: short-term

capital can fly out of the country extremely rapidly if there is any whiff of a crisis. Opening up primarily to short-term capital, however, made complete political sense: the chaebols need the money and it is much easier to borrow short-term funds at lower interest rates in the international market because long-term lending is much riskier for foreign creditors. Keeping restrictions on long-term international borrowing, however, allowed the government to say that it was still restricting foreign capital inflows and to claim that it was opening up to foreign capital in a prudent manner.

In the aftermath of these changes, Korean banks opened branches in foreign countries that gave them Access to foreign funds. Although Korean financial institutions now had access to foreign capital, the chaebols still had a problem. They were not allowed to own commercial banks And so the chaebols might not get all of the bank loans that they needed. What was the answer? The chaebols Needed to get their hands-on financial institutions that they could own, that were allowed to borrow abroad, and that were subject to very little regulation. The financial institution could then engage in connected lending by borrowing foreign funds and then lending them to the chaebols who owned the institution. An existing type of financial institution specific to South Korea perfectly met the chaebols' requirements: the merchant bank. Merchant banking corporations were wholesale financial institutions that engaged in underwriting securities, leasing, and short-term lending to the corporate sector. They obtained funds for these loans by issuing bonds and commercial paper and by borrowing from interbank and foreign markets. At the time of the Korean crisis, merchant banks were allowed to borrow abroad and were almost virtually unregulated. The chaebols saw their opportunity. Government officials, often lured with bribery and kickbacks, allowed many finance companies (some already owned by the chaebols) that were not allowed to borrow abroad to be converted into merchant banks, which could. In 1990 there were only six merchant banks and all of them were foreign-affiliated. By 1997, after the chaebols had exercised their political influence, there were 30 merchant banks, sixteen of which were owned by chaebols, two of which were foreign-owned but in which chaebols were major stockholders, and twelve of which were independent of the chaebols but Korean-owned. The chaebols were now able to exploit connected lending with a vengeance: the merchant banks channeled massive amounts of funds to their chaebol owners, where they flowed into unproductive investments in steel, automobile production, and chemicals. When the loans went sour, the stage was set for a disastrous financial crisis.