IMF Bailout of Korea During East Asian Financial Crisis (Part I)

Dear Korean,

I've often heard from my parents about the IMF-Korea bail out and how it was "actually" some big conspiracy that pushed Korea further into debt. They also mention how everyone in Korea united and melted their gold jewelry to pay off the debt. As much as I love my parents, I know they have rather slanted views when it comes to Korean history, economics, and/or politics. I would like to know, as objectively as possible, about the IMF-Korea bail out and how Koreans reacted to it and feel about it to this day.

2nd Generation

Dear 2nd Generation,

The Korean always found it a good policy to listen to someone who knows better than you do. So for this question, the Korean consulted with Wangkon936, who is a regular guest blogger at a popular Korea-related blog and far more knowledgeable about the East Asian Economic Crisis than the Korean himself, at least as far as the economics part is concerned.

Since this is a big topic, it will proceed in several parts. Wangkon936 will first discuss the mechanics of how the financial crisis started, followed by the Korean's discussion of the crisis' sociological impact Korean society. Below is Wangkon936.

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It is not an exaggeration to say that East Asian Financial Crisis was a traumatic event for Korea. Not too long ago before the crisis, Korea became the 11th largest economy in the world and its per capita GDP had reached a milestone of $10,000.  The reform programs mandated by the IMF was humiliating to the country who had thought that they had turned a corner from decades of economic hardship and struggle and was close to reaching the exclusive club of the advanced economies of the world.

The sudden, almost hurricane or earthquake-like change in fortune was hard for most Koreans to bear, let alone understand.  So in an attempt to explain what they could not many Koreans viewed the crisis as being fueled by foreign speculators driving down the value of their currency, foreign lenders prematurely calling in their loans and a foreign IMF that did not care about the businesses they drove into bankruptcy, the people laid off from their jobs or the dreams of the people that all this sudden hardship destroyed.  Some desperate families, in dire economic straits, left their children at orphanages and these kids were called “IMF orphans.”  The acronym “IMF” in Korea became a symbol of every malaise that the country was going through at the time.  It literally became a new word in the Korean vocabulary as to many IMF stood for “I'M Fired.”

More after the jump.


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East Asian Financial Crisis -- the Challenge of a Developing Economy

Korea was part of what many economists would call a “contagion.”  If you think that sounds a lot like the word “contagious” you are right.  An economic contagion is a situation where the economic problems of one nation, for reasons too complex to discuss in this blog, spread to another.  The crisis started in Thailand, then spread to Malaysia, Indonesia, The Philippines and South Korea.  These countries, to various degrees, fell like dominoes as their currencies were attacked by currency speculators and devalued. 

Developing countries, be it Mexico, Thailand or Korea of the 80's and 90's raised a lot of foreign debt so they could buy the means to develop.  In order for poor countries to raise their standard of living, they need to manufacture, mine or drill and pump out the things that developed countries want.  Sometimes these things are oil (the Middle East), raw diamonds and minerals (Africa), cars (Japan) or consumer products (China).  To extract oil or to make cars and consumer products you need machines and expertise that the developed countries have such as oil drills, metal stamping machines, lathes, sewing machines, injection molding machines, etc. otherwise known as “capital equipment.”  The only way a developed country will sell you capital equipment is if you buy it with their currency.  So, here is the developing country's fundamental challenge: one must borrow money from developed countries to buy their capital equipment then provide the developed countries with the goods they want so they will give you more of their currency so you can in turn raise your own productivity and pay off your debt to them.  A rather simplified model, but correct enough to suit our purposes here. 

The main problem for many developing countries is growth.  They must maintain strong growth rates otherwise it will be harder for them to pay off their debts to the developed countries.  Latin America has has mixed success to meeting this challenge.  For Africa it's largely been a disaster.  However, Japan succeeded spectacularly with this model and it looks like China is making good progress thus far.  From the 80's to the mid-90's the newly developing countries of East Asia were on a tear with annual growth rates between 7-9%, a blistering rate compared to the more sedate growth rates of 2-3% for the typical developed country.  However, by the mid-90's the newly developing East Asian countries were facing some problems.  Their strong grow rates were slowing because they had relied mostly on moving labor from the countryside and into the factories, but not in meaningful improvements in technology and efficiency.  To maintain their growth rates some of these countries started to “stretch” and take unnecessary risks. 

Let's take a step back and consider what this means. Suppose you own a factory with five workers, who make hand-woven baskets by hand. One way to improve your productivity (and create more baskets in the same amount of time) would be to hire additional basket weavers. Another way to improve your productivity would be to find an innovative way to weave baskets faster. East Asian economy grew primarily by adding more people without making as much innovation. (Again, this is all extremely simplified.) So when East Asian economies no longer had additional manpower to throw into the factories, problems began to boil up.

Case in point.  Thailand decided to build a lot of commercial buildings to encourage the development of business services such as a strong financial services sector like those that existed in Hong Kong and Singapore.  However, it wasn't working and all those newly built commercial properties had too many vacancies.  Thailand did try to “liberalize” its financial systems to help them develop faster and the get foreign financial institutions to move operations into their country, but that didn't work either. The Thais just didn't have the education base, experience or track record to develop a competitive financial services sector.   Because Thailand had a lot of real estate that was not bringing in revenue, their economy was full of what was called “non-performing loans" -- essentially, the loans that were not getting repaid by the borrowers. With a lot of overvalued properties and rising portfolio of non-performing loans the Thai economy slowed down. Thus, the Thai baht looked overvalued to currency speculators and they attacked, betting that the Thai government wouldn't have enough foreign currency to defend the baht. 

Currency Under Siege

Here, we need to understand a couple of concepts. One is short term loans.  Developing countries took on a lot of short term loans because they were considered riskier investments by the lenders of the developed world and are thus easier for developing countries to get.  The term of these loans are 12 months, meaning technically these loans need to be completely repaid within a year.  Most short-term loans are merely refinanced every year.  However, if the economic situation is unstable, given the greater risk of these short-term loans, banks can decide to not renew them and/or call them up early.

The other is foreign currency reserves, which are funds held by a nation's central bank (their version of a Federal Reserve) to stabilize their nation's currency.  For the purposes of understanding the concepts in this post, there is another function of foreign currency.  Think of it as the last reserve of having just in case your lender suddenly wants to its debt repaid ahead of schedule.  In other words, it's the last resource that a nation's central bank has in order to pay off their foreign debts if those debts suddenly and unexpectedly become due.  Think of it as a family's chest of jewelry that has quickly exchangeable value anywhere, at any time, just in case of an emergency to get you out of a pinch. So if the Thai baht or Korean won's value plummets, those respective countries can meet their short-term obligations to foreigners through their foreign currency reserves. 

Let us apply this to the Thailand situation. For ten years the Thai economy had enjoyed an average of 9.4% annual growth with only 4.7% inflation.  It looked like Thai was pulling an economic rabbit out of its hat.  But they weren't.  As mentioned before, the Thai economy by late 1996 had shown signs of strain.  It grew quickly and tried to maintain the fast growth rates, but had precariously stretched themselves which resulted in a commercial real estate bubble.  As the Thai economy slowed and strained its currency was attacked by currency speculators.

So, what's a currency speculator and why do they attack currencies?  To begin to answer these questions, we have to explore the question of what money really is.  Money nowadays has “intrinsic” value.  A dollar bill has no value in itself.  It's just paper and ink.  The value of money in the modern age is essentially what the market thinks it is.  Yes, this concept is strange when you sit down and think about it, but it wasn't always like this.  Up to about the  late 1970’s, the world had a “gold standard” where a unit of a country's currency was theoretically worth a declared amount of gold redeemable by the government.  The government's central bank would promise that an X amount of their currency would be worth a Y amount of gold.  Well, that ended in 1971.  So, since then a country's currency is whatever people think it is.  Alright, that might be a little bit of an exaggeration, but theoretically it is “guaranteed” or made “legal tender” by the country's ability to raise tax revenue, or in other words, reap productive and valuable resources from its citizens and businesses.  It's almost like a publicly exchangeable stock on an entire country.  My old college economics professors probably won't like that analogy, but it will suffice for now.

Currency speculators are needed in the marketplace.  They enable developing countries, like Thailand, to get foreign currency to buy foreign goods.  Likewise, they are needed to help foreign companies buy Thai currency so they can buy Thai products.  However, currency speculators are not around to just help people.  Like any financially minded commercial institution, they are around to make a profit.  Currency speculators make money on manipulating the “spread” or “arbitrage.”  In other words, buy one currency cheaper and sell it for a higher price.  They use derivatives and leverage to “amplify” their returns.  It took me a semester of international finance to figure out how they make massive amounts of money on derivatives based on currency fluctuations so there is no way I can explain it in a few sentences.  It is sufficient to know that foreign currency speculators can make a lot of money if it makes a lot of correct “bets” on a nation's currency.  If the bet is against a currency then this can accelerate the decline of that currency.  Although this concept may be difficult for many lay people to immediately comprehend, it's something that needs to be understood to some degree before one can properly appreciate what happened to Korea and the other newly developed East Asian economies at the time.

So, in any stock market, who determines the price?  Demand does.  The higher the demand the more “valued” the currency is.  What determines demand?  Investor confidence in the country.  Why would investors lose confidence in a country?  The same reason all investors lose confidence.  They lose confidence because the country may have a declining ability to meet its debt obligations.  So, in Thailand's case its debt rises, its economy slows and its real estate bubble begins to pop.  With those things going on people begin to doubt if the nation can pay its debt obligations to foreign lenders.

Thailand's currency, the baht, was under pressure in the early summer of 1997, as currency speculators attacked it by making “bets” that it was overvalued due to the underlying weakness of its economy.  The Thai central bank had no choice but to flood the market with foreign currency from their foreign currency reserves to buy back the baht that the currency speculators were dumping into the market.  They were thus “creating” demand to keep the value of their currency stable.  However, at this time Thailand's foreign currency reserves were modest and not enough to sufficiently counter the bets made against it by speculators.  With Thai's foreign currency reserves exhausted they could no longer maintain the peg to the major developed currencies and the value of the baht fell like a meteor.  With the baht's value dropping in half Thai's short term lenders panicked.  A sudden decline in a country's currency effectively multiplied the debt by how much the currency declines.  So if the currency declines in half, it effectively doubles the debt.  Thus, the mostly foreign short-term lenders either called in their loans early or said they wouldn't refinance the loans.  Thailand was in default and had to get a loan from the IMF to cover their short term debts.

However, the emergency IMF loans that helped the Thais to pay off their short term debt obligations didn’t come without its costs and consequences.  The IMF mandated, as a precondition to obtaining the loan, a balanced government budget, ample foreign currency reserves, controlled inflation, etc.  All these things sound good, but the problem was that the Thai government had to do implement all of this virtually immediately, which caused a good deal of austerity and hardship for its citizens and businesses.

Thus, this similar pattern spread to other formally fast growing East Asian economies as the contagion spread to Indonesia, then Malaysia and ripples were felt worldwide.  The last but largest casualty of the contagion was South Korea. How South Korea fell and what lead to its financial demise, if this demise was “fair” or “unfair,” and if external (i.e foreign) parties like the IMF had an undue responsibility will be the topic of part II.



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