13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (8 page)

—Korea Letter of Intent to the IMF, December 3, 1997
¹

In the mid-1990s, financial crises in less developed parts of the world were only too common. Mexico had a major meltdown in 1994–1995 and former communist countries such as Russia, the Czech Republic, and Ukraine struggled with severe financial shocks. Then in 1997–1998, what seemed like the mother of all international financial crises swept from Thailand through Southeast Asia to Korea, Brazil, and Russia. The contagion even spread to the United States via Long-Term Capital Management (LTCM), an enormous and terribly named hedge fund, which came to the brink of collapse.

In the United States, economists and policymakers took two main lessons from these crises. The first was that crises could be managed—by pushing other countries to become more like the United States. Through the experiences of 1997–1998, the U.S. Treasury Department and the International Monetary Fund (IMF) developed a game plan for handling financial crises: structural weaknesses such as a failing financial sector had to be dealt with immediately, without waiting for the economy to stabilize. Both directly and through their influence over the IMF, the key architects of U.S. economic policy—Treasury Secretary Robert Rubin, Deputy Treasury Secretary Larry Summers, and Federal Reserve chair Alan Greenspan—pressed crisis-stricken countries to liberalize their financial systems, increase transparency in their political systems, and model the governance of their corporations on the Anglo-American system (with a greater role for mutual funds and other institutional investors). For their pains, the Rubin-Summers-Greenspan trio was featured on the cover of
Time
magazine as the “Committee to Save the World.”
²

The second lesson was that while the U.S. economy was not completely immune to financial panics, any real damage could be contained through a few backroom deals. At the urging of the Federal Reserve, LTCM was essentially bought out and refinanced by a group of private sector banks, preventing a major crisis; a series of interest rate cuts by the Fed even kept the stock market bubble growing for another two years. The mature U.S. financial system, it seemed, could withstand any infection that might spread from the developing world, thanks to its sound financial system and macroeconomic management.

Crises were for countries with immature economies, insufficiently developed financial systems, and weak political systems, which had not yet achieved long-term prosperity and stability—countries like Thailand, Indonesia, and South Korea. These countries had three main characteristics that created the potential for serious instability in the 1990s: high levels of debt, cozy relationships between the government and powerful individuals in the private sector, and dependence on volatile inflows of capital from the rest of the world. Together, these ingredients led to economic disaster. Debt-fueled booms, collapsing bubbles, and panic-stricken financial systems were all reminiscent of the Crash of 1929, but the conventional wisdom was that the United States had put these growing pains behind it, thanks to strong corporate governance, deposit insurance, and robust financial regulation. Emerging market crises were an opportunity for the United States to teach the world how to deal with financial crises. Few people suspected that, despite the many obvious differences between emerging Asian economies and the world’s largest economy, some of those lessons would become relevant to the United States only a decade later.

ANATOMY OF EMERGING MARKET CRISES

In the 1950s, South Korea was one of the most economically backward countries in the world, ravaged by war and a half-century of Japanese oppression. No outside observer would have regarded it as a candidate for rapid economic development. By 1997, however, South Korea had arrived—literally, having joined the club of rich countries, the Organization for Economic Cooperation and Development (OECD), in 1996.
³
Korea’s leading companies were fast building global reputations in a wide range of technology-intensive sectors, including shipbuilding, computer chips, automobiles, and consumer electronics. Top family-owned business groups (“chaebol”) such as Samsung, Daewoo, Hyundai, and LG were increasingly prominent global brands. Korea also benefited from a stable political system, with relatively open elections dating back to 1987.

However, Korea exhibited some of the classic weaknesses that produce emerging market crises. Economic activity was dominated by the giant chaebol, whose weak governance structures did little to constrain the whims of their founders. Hostile takeovers were essentially impossible due to a web of local rules. Institutional shareholders did not effectively monitor or control management.
⁴
The chaebol were also deeply in debt: Samsung’s debt was 3.5 times its equity, Daewoo’s was 4.1 times, Hyundai’s was 5.6 times, and so on.
⁵
Leverage (the ratio of debt to equity) in the corporate sector was more than twice that of the United States.
⁶

In earlier decades, the chaebol had been kept in check by state-owned banks that had carefully allocated credit, limiting the risk that the system would get out of control.
⁷
By the 1990s, however, the tables had turned. The chaebol had grown big enough to become a political force of their own.
⁸
Helped by their newfound political influence, they were in position to borrow on advantageous terms, making it possible to run up debt cheaply. Because Korea was regarded as having a sufficiently mature financial market, symbolized by membership in the OECD, its banks could easily borrow short-term money overseas and make longer-term loans to the corporate sector. Alternatively, the chaebol could borrow directly from foreign banks that were now eager to lend to Korea’s booming economy.

The availability of cheap short-term debt led the chaebol to splurge on long-term capital investments. The head of Samsung decided that he needed to add an automotive wing to his already far-flung group—an expensive bet that turned out badly. The founder of Daewoo expanded aggressively into the former Soviet bloc, building manufacturing plants from Eastern Europe to Central Asia, and also placed a big bet on cars. Korean manufacturers, led by Samsung and LG, invested heavily in DRAM chip production capacity, driving down margins. These questionable investments, made possible by cheap borrowing, caused returns on capital to fall—making it harder for the chaebol to repay their ever-increasing debts.

Trouble first appeared in 1996 and early 1997 among smaller chaebol who had made risky bets with borrowed money, attempting to move up to the top tier. Hanbo Group (based on a major steel operation), the number 14 chaebol in 1995,
⁹
defaulted on its debts in January 1997; Kia, the carmaker that was investing heavily to break into the U.S. market, was also in serious financial trouble.
¹⁰
The government stepped in with various rescue packages, even for relatively small chaebol, typically providing subsidies or other forms of assistance so that a relatively healthy company could take over a failing company and limit job losses.
¹¹
The largest firms enjoyed stronger implicit government guarantees—the conventional assumption that the government would not let them go under—which helped protect them from failure.
¹²
Still, by summer 1997, six of the thirty largest business groups had gone bankrupt.
¹³

The Korean model and its high short-term-debt levels seemed sustainable as long as economic prospects looked strong and investors thought that companies could pay them back. But financing long-term investments with short-term foreign debt creates a major vulnerability: if lenders start to worry about getting repaid, they will try to pull out their money (refusing to roll over loans); but because companies put that money in long-term investments, they will not be able to pay it back on demand. In this situation, borrowing in U.S. dollars only increased the vulnerability—fears that a country is in trouble can become self-fulfilling as foreign bankers and bondholders scramble to pull their money out first, triggering the defaults that they were afraid of.

For the first nine months of 1997, the Korean economy grew at an impressive rate of around 6 percent.
¹⁴
In July, however, the “Asian financial crisis” broke out in Thailand as a crisis of confidence caused a collapse in the local currency, the baht. Overleveraged companies saw their debts double practically overnight (because their debts were in foreign currencies, the amount they owed doubled when the value of the Thai baht fell by half) and were forced to default, causing mass bankruptcies and layoffs. One month later, the crisis spread to Indonesia, where the currency collapsed and domestic companies failed.

At first investors assumed that Korea was sufficiently developed to withstand the storm, but anxiety was spreading outward from Southeast Asia. On October 23, the Hong Kong stock market declined sharply, rattling investors. Then Standard & Poor’s downgraded Korean sovereign and corporate debt, stoking fears that Korea would be the next country to be hit by the crisis.
*
Financial markets started to think again of Korea as an emerging market subject to high economic volatility, which made its short-term debt levels seem excessive. Foreign banks became reluctant to roll over their loans and new international financing became hard to obtain. The currency depreciated sharply, falling from 886 won per dollar in July to 1,701 won per dollar in December. Everyone with dollar debts was hit hard, since now it took twice as many won to cover the same dollar debt payments.
¹⁵

The Korean government attempted to stabilize the situation, using its foreign exchange reserves to help state-owned banks pay off their foreign debts and to slow down the depreciation. But it could not stop the downward spiral—as the currency fell, it became harder for companies to repay foreign debts, and as some fell behind on repayments, creditors became more reluctant to roll over the debts of others.
¹⁶
The stock market declined sharply and credit collapsed as banks, unable to pay their own foreign debts, reacted by cutting off loans to domestic companies—which made it harder for companies to produce the exports they needed to pay off their debts.
¹⁷
The economy declined sharply, leading to layoffs and street protests.

The International Monetary Fund, an intergovernmental organization charged with helping countries in economic distress, did provide financial support subject to some conditions. The IMF emergency lending program put limits on bailouts to the corporate sector, insisted that support to the banking system become transparent and that insolvent banks themselves be taken over, and outlined changes in the governance of chaebol to limit overinvestment. Many of these ideas were strongly supported by Korean reformers working under new president Kim Dae-jung, who wanted to take advantage of chaebol weakness to push through reforms that would make future growth more sustainable—in part by reducing what he saw as the economic and hence political clout of the chaebol.
¹⁸

But the IMF program also contained three striking and controversial dimensions. First, consistent with the view of the U.S. Treasury, it insisted on tightening monetary policy and, despite the strength of the government’s balance sheet, did not condone an increase in government spending to offset the contraction in the private sector.
¹⁹
As a result, Korea was unable to cushion its economic downturn with the type of stimulus package and low interest rates deployed by the United States and most developed countries in 2008–2009.
²⁰

Second, in the debt renegotiations with foreign lenders, which involved the U.S. Treasury closely,
²¹
there was no write-down of the amount owed by Korean banks; although the United States did help force creditors to roll over their loans, the amount they were owed did not change. So while Korean companies were left to struggle, foreign banks and bondholders were effectively bailed out of their poor lending decisions—giving them no incentive to avoid the same mistakes in the future.
²²

Third, the IMF insisted that Korea needed to become
more
open to foreign capital, quickly. Paragraph 31 of the Letter of Intent between Korea and the IMF reads as follows:

To increase competition and efficiency in the financial system, the schedule for allowing foreign entry into the domestic financial sector will be accelerated. Foreign financial institutions will be allowed to participate in mergers and acquisitions of domestic financial institutions in a friendly manner and on equal principles. By mid-1998, foreign financial institutions will be allowed to establish bank subsidiaries and brokerage houses. Effective immediately foreign banks will be allowed to purchase equity in domestic banks without restriction, provided that the acquisitions contribute to the efficiency and soundness of the banking sector.
²³