Arguably, the Asian Financial Crisis of 1997 was one among the worst financial crises in the history of the world. Only comparable to the Great Depression in the United States and the Lost Decade of Japan, the Asian crisis was one that saw many countries from the region, SouthKorea being the most noteworthy, crumbling down in the economical sense. The crisis saw big companies in South Korea resort to such measures and alternatives like conglomeration through significant business mergers. The organizations that were affected include the biggest and most renowned companies, most of which were either taken over or acquired by big multinational corporations (Masahiro et al 4). Such big household names as Samsung and KIA Motors suffered in equal measure during the crisis. The IMF bailout was not the best of experiences to South Korea, then one of the fastest growing economy markets. Today South Korea is back on its feet. After the crisis, South Korea came back with a bang and hit the ground running. Today, the GDP of South Korea is triple the figure it was prior to the dark period, thanks to the capital controls that were employed. This paper, through review of literature, endeavors to explain how various capital controls can be used in effectively stabilizing an economy. The paper as well demonstrates how other political alternatives can be employed in enhancing the effectiveness of the capital controls.
Review of literature
According to many scholars, the main causes of the crisis in korea revolve around the fact that the financial activities relating to foreign financing were too many for the Korean economy to achieve financial stability. The immediate cause, according to many scholars, was the current account deficit of approximately 8.7 billion US dollars (Rude 67). The deficit was occasioned by such things as the appreciation of the won, the risisng inflation and the overall recession of the world economy. Prior to the crisis, south korea had the highest growth rate among all developing countries, with the rate shifting between 7 and 9 percent.
Economists argue that the exponential growth that characterized the Korean ecoomy prior to the crisis is another likely cause of failure. Typically, such exponential growth is characterized by too much foreign borrowing, a situation that is most likely to plunge the economy into deep trouble. Prior to the economic crisis, the ratio of foreign debt to the gross domestic product (GDP) stood at 30% (Rude 90). During this time, the government under the leadership of president Kim Dae Joong, allowed too much external borrowing and investments relating to the external economies. Many economists have argued that the main reason why the crisis was so much prolonged was because the government of President Kim Dae Joong could not resolve all the matters relating to the middle class urban population and the working class (Karl et al 91). The move by IMF to bail out south korea has been described variously as a move that saved the country out of a possible sovereign default.
Effectiveness of capital controls in the Asian Financial Crisis of 1997
During the Asian Financial Crisis of 1997 the banking sector of Korea was among the most victimized sectors of the economy. This was due to the prominently non performing loans that were issued to the big organization s that were seeking to expand exponentially. The expansion program has been variously described as the aggressive expansion of the industrial sector (Sachs 12). The organizations borrowed heavily from both private and public institutions – both local and international. Most scholars note that with time, all the organizations were burdened with loans that they could not service, amid the rising Asian Financial Crisis of 1997. As a result, organizations lost their corporate image with others undergoing acquisition and others ceasing to exist as a result of violent takeovers. Most prominently, the Daewoo motors, a big automobile organization was sold to the American organization, General Motors. Similarly, Samsung motors, valued at five billion dollars were dissolved at a time when the Korean Won hit a devastating point where it traded at 1700 against one US dollar.
Most scholars note that the Seoul Stock Exchange (SSE) failed terribly, upto an extent of 4%. At this point, most organizations were not performing competitively, with most of the big organizations achieving zero returns and negative profitability. It is worth mentioning that according to many scholars, the biggest indication of the Korean failure was the point at which the credit rating of the organization was reduced from A1 to A3 (Masahiro et al 11). On November 1997, the credit rating was further reduced to B2. By the 24th of November, the stocks on the SSE had dropped by 7.2%. This saw the takeovers of many organizations whose stock value had deteriorated a great deal. Most prominent example of the takeovers was seen when Hyundai took over KIA motors, one of the household names in the automobile industry.
According to many scholars, the causes of the Asian Financial Crisis of 1997 revolve around the fact that the Asian economies had become so much integrated with the global markets. Such integration had come with so many negative influences, the most common being imported inflation and unfair competition. The industries in Korea had not fully developed. On the contrary, they were only picking up the pace. The coming of the foreign firms posed unfair competition. These saw the decline of the local industries. Another notable cause was the lack of hedging. The lack of hedging exposedmany organizational transactions to business risks posed by the international business environment (Chikako and Anna 19). Foreign currency borrowing was another noteworthy cause of the crisis, with most organizations seeking to expand significantly within the decade. Such borrowing plunged the economy of Korea into problems, when the organization ran bankrupt prompting soaring levels of unemployment – a phenomenon that is associated with a number of societal negatives.
The intervention of the IMF was one historic bailout that would see the Korean government institute a number of controls, specifically capital controls that would lift the economy to great heights. The capital controls employed by the Korean government saw the organizations review their strategies, especially the sources of funds (Edwards 31). It may be important to mention that the capital controls were aimed at the cross border regulations. It is critical to understand that capital controls are concerned with reducing the volume of cross border trade. Further, the capital controls focus more on the financial endeavors of the organizations. Capital controls are not so much concerned with the short term transactions, but rather with the cross border investments. As such, the controls relate to investing across the borders. This is what is referred to as cross border investing of foreign direct investment (FDI). Essentially this saw the organizations’ investments in real estate go down a great deal. Capital controls are therefore the measure put in place to enable the government determine the level of foreign investments within the borders of the country, and the volume of local investment abroad.
As a reaction to the Asian Financial Crisis of 1997, the Korean government placed limits on the amount of investment that the local investors could do outside the borders of the country. These limits were referred to as FDI ceilings. They were referred to as ceilings because, fundamentally, the main aim of the measures was to curtail the volume of investment. They set the maximum but not the minimum. These capital controls was aimed at having the investors pursue their financial endeavors from within the borders as a way of boosting the local economy. The government did not lay a total ban on foreign investments as this would not only be impracticable, but also detrimental to cross border relations (Masahiro et al 18). Such ceilings ensured that the extra finances were committed to promoting the local economy. There are so many advantages that accrue to having many organizations invest within the local economy. Among the many advantages that accrue to having local industries invest within the borders is the reality that such a decision boosts the local currency. Besides boosting the local currency’s value against other currencies, the local investors offer employment opportunities – a thing that empowers the citizens and improves their purchasing power.
In addition to the foreign investment ceilings the Korean government instituted an upper limit for the Korean insurance firms. Such firms are among the most important stakeholders in many businesses within the economy. It may be important to mention that during the time when the insurance organizations are limited, the business people are capable of trading within much fear regarding the possible uncertainties inherent in the local economy (Chikako and Anna 26). Such capital controls were accompanied by strict requirements that all organization had to report their results to the ministry of finance. Such transparency helped identify possible fertile grounds in terms of investment. Additionally, the reporting served such purposes as transparency for taxation purposes. Besides upholding transparency, the reporting requirements helped the government check on the amount of foreign investments held by the organizations. From the reports, the government as well got to check on such important aspects as the repatriation of profits from international business endeavors.
As mentioned earlier, capital controls prominently focus on the real estate investments. Such real estate investments are among the most permanent investments. As a way of encouraging growth in the local economy, the Korean government put a strict limit on the amount of real estate that an organization could put up outside the borders of the country (Edwards 27). Limiting external real estate investment boosted the growth of the local economy in such a way that it boosted infrastructural enhancement in the economy. Investment in real estate deals with such things as buildings and other premises that can help the local investors and traders establish businesses and industries without much hassle. The effectiveness of the capital controls employed by the Korean government began to be noticeable within less than two years of their institution. Noteworthy is the reality that the above discussed capital controls were accompanied by strong and strict legislation.
Apparently, the effectiveness of the capital controls has been seen in the tremendous economic growth that is being experienced in South Korea currently, and especially in the last decade. The last decade saw South Korea emerge as the undisputed leader of the emerging market economies (EME). With such companies as Samsung investing heavily in the local economy, the capital controls that were laid back in the day are worth noting. Apparently, such economic growth has been associated with notable reduction in unemployment over the years(Karl et al 32). Noteworthy is the actuality that investing in the local economy, a mega decision advocated for by the Korean government created many jobs within the economy. As can be seen from the curve below, unemployment has decreased considerably since the late 1990s.
South Korea - Seasonally Adjusted Unemployment, %
The above graph indicates that there was asignificant increase in the levels of unemployment during the great crisis. Notably, going by unemployment rates, there was a significant improvement in the period just before the financial crisis. This declined between 1997 and the year 2000. This explains that the capital controls forced the local investors to commit there funds to real estates and other long term investments within the country. Such investments created many job opportunities within the economy. This saw the unemployment rate drop significantly through the 2000s. the reduction in unemployment is an indication of economic growth, as stated clearly in the thesis.
Another indication f the effectiveness of the capital controls is the fact that the country was capable of paying the IMF development loan in 2001 august – a date that was exactly three years ahead of the deadline. This is a clear indication that the foreign investments ceiling had encouraged growth of the local economy in such a manner that the country was able to repay the IMF loan without having to create another debt elsewhere. It may be important to note that by the year 2002, the credit rating of South Korea had been changed to A2 right from B2 (Masahiro et al 24). This is a great improvement considering that the metrics by which the IMF and the World Bank come up with the credit rating are quite stringent. The international monetary fund described the economic growth of Korea in the 2000s as “quite impressive”.
The effectiveness of the capital controls was as well manifested in the manner that the organizations that were almost collapsing raised to become the world’s leading companies in various sectors. Talking of communication technology, Samsung is the undisputed champion, with Apple Inc being the closest competitor. Such automobile makers as KIA Motors are currently among the most respected brands even after the Asian financial crisis pushed them to the verge of failure (Sachs 24). The economic growth, which is enviable by many third world nations, has seen Korea attract a number of foreign investors, including those that shied away from the falling economy in the late 1990s. The economy is currently growing at a rate that is likely, according to most economists, likely to see the country rise to the levels of social development currently being experienced in Kuwait. The economic growth can be seen in the trend below.
The source: http://www.heritage.org/research/reports/2007/12/economic-lethargy-south-korea-needs-a-second-wave-of-reforms
As can be seen from the graph, the economy of south korea has improved a great deal since the 1997 crisis. The crisis saw the country’s economy fall drastically, but after the year 1998, positive change associated with the application of the capital controls was noted. It is worth noting that the economy improved more steadily as the capital controls were met with stricter enforcement. The graph reflects the thesis, which is centered on the effectiveness of the capital controls.
Currently, the capital inflows in Korea are unprecedented in Asia. The foreign investors are tending to prefer the South Korean market, especially considering that it appears promising in the economic sense. The strong economic growth is motivated by the lucrative export industry. The export industry is characterized by increased hedging of export revenues associated with the local ship building industry. The ship building industry of SouthKorea is notably the most lucrative in the world, and brings significant revenue to the Korean economy. The capitals controls are currently being relaxed but have, over the past decade seen the country achieve significant resource accumulation and short term foreign debt. Such short term foreign debt is a clear indication that the credit rating of the country is improving by day. The improvement appears sustainable as the capital controls have seen the country attain high savings.
The political alternatives
The Korean government under the leadership of President Kim Dae Joong took a number of political moves towards securing the economy of the country. Among the primary moves that the country’s government took, was the decision to engage the G – 7 countries to mobilize other international financial institutions to offer a bailout to the country, whose economic condition was quite devastating. This saw the G7 influence the IMF and the international financial community mobilize 58.4 billion US dollars, which saw the country make reserves worth 23.4 billion dollars that were set aside as second line defense in an endeavor to prevent the possible occurrence of another similar crisis.
Notable among all the political efforts was the decision by President Kim Dae Joong to persuade the US government to talk the IMF into nailing out the country. This decision, which was executed on the 19th day of December, saw the IMF open negotiations with the government of President Kim Dae Joong. The negotiations included the drawing of a long term plan that was later to help the country plan for preventing yet another possible crisis. Talking of political approaches, the government took a forward looking approach in regulating liberalism in the private sector. Such liberalism was among the main causes of economic paralysis. Apparently, the president and the government played a critical role in reinforcing the capital controls with sufficiently strong legislation.
Apparently, the economic controls have seen the economy of South Korea spring back to life, after what economists describe as the United States’ equivalent of the great depression or japans’ equivalent of the lost decade. Worth noting is the actuality that the above discussed measures are purely economic. There are some measures with a political outlook. Such measures are in such a manner that they not only focus on the economic well being of the country and its citizens, but also the sustainability of the relationship between a country and its neighbors, allies and trading partners (Sachs 19). It may be important to mention that when the economic controls are instituted, there is a high likelihood that the relationship between a country and those it deals with will be affected. When such is the case, it is a matter of common knowledge that the country will suffer significantly as a consequence of the sour relations. This explains why, there are some political solutions that can effectively replace the economic controls or, those that can be used hand in hand with the economic alternatives.
The first political solution to such a crisis as the one that hit Korea and a substantial part of Asia is the decision to form trade blocks and to engage in economic integrations (Rude 16). As a matter of fact, the EuropeanUnion is undoubtedly the strongest regional integration globally. It is a matter of common knowledge that the European Union is based on political ideology. The political philosophies of the union bind the member together in such a way that they cannot engage one another in conflict, especially armed conflict. It therefore follows that political ideological integration can help the countries come out of a crisis. If the Great Britain was to go into a financial crisis today, it probably won’t happen because the country is strongly rooted in the economic integration in such a way that the allies would effortlessly bail out the sinking economy. Engaging in such integration can empower countries economically, such that they are stable, and can obtain loans from the block’s reserves at zero interest.
Another political solution that the country can embrace is the use of bilateral agreements. Bilateral agreements are agreements that function in such a manner that the agreements, usually referred to as trade covenants are established between two nations, with either nation being obliged to work with the other as a preferential trade partner. By preferential, it means that the political agreements could be of such nature that the two countries suspend tariffs and quotas on all gods imported from the partner country. It may then imply that the countries in the agreement will be in a position to bail out one another in the event that there is a financial crisis affecting a partner country. Bilateral agreements have worked in many nations, and are particularly common in the developing economies, where the currencies are at risk, considering that the nations import heavily. A multiplicity of trade agreements form block that is referred to as multilateral agreements. Multilateral imply that the relationships are in such a way that a country is surrounded by a number of trading partners. Without such restrictions as tariffs, quotas and embargoes, the countries can assist one another in the event that there is a financial crisis.
As mentioned earlier, the political agreements can as well be coupled with the economic agreements and measures as a way of cutting down on any possibility of there being conflict. Looking at it critically, if a country lays an embargo, usually referred to as a total ban on goods from another country, there is a high likelihood that the other country will retaliate by quitting trade with the nation laying embargoes. Such actions and reactions will eventually prove to be detrimental to both countries as they will not be able to access the commodity they initially imported from such country. It therefore follows that in planning economic policies and restrictions, the country should at all times endeavor to consider the effects of such a policy on the relationship between the countries (Rude 6).
In conclusion, it is worth noting that the South Korea is one of the countries that were worst hit by the 1997 financial crisis. The country saw its banking sector crumble down. The IMF bailout was essential, yet quite humiliating in the sense that the perceived strongly growingeconomy was down on its knees. The government, as a way of improving the economy came with capital controls that revolved around governing the cross border business and investments. Apparently, the capital controls came out as the most effective tools of economic growth and sustainability as South Korea managed to pay the loan in time. Scholars have however advocated for the combination of both political and economic measures, for the sake of cross border relationships.
Chikako Baba And Anna Maria Kokeny. “Effectiveness Of Capital Controls In Selected Emerging Markets In The 2000s.” IMF Working Paper. 2011
Edwards Sebastian. “How Effective Are Capital Controls?” The Journal Of Economic Perspectives. 1999
Karl Habermeier, Anna Maria Kokenyne, And Chikako Baba. “The Effectiveness Of Capital Controls And Prudential Policies In Managing Large Inflows.” IMF. 2005
Masahiro Kawai, Richard New & Sergio L. Schmukler. “Financial Crises: Nine Lessons From East Asia.” World Bank. 2008.
Rude, Christopher. “The 1997-98 East Asian Financial Crisis: A New York Market-Informed View.” Expert Group Meeting. 1998
Sachs, Jeffery. “The East Asia Financial Crisis: Diagnosis, Remedies And Prospects.” Brookings Papers On Economic Activity. 1999