Lessons Of The Korean Crisis
The economic crisis in South Korea was a long time in the making. Whilst its immediate cause was the inability of the Korean private sector to service its short-term foreign debt denominated in dollars, both the type of foreign capital flows Korea has relied on as well as the dirigiste system of industrial planning maintained by the authorities provide more fundamental reasons for the debacle.
In India, the East Asian crisis is already being used to argue against liberalising the external sector, as an attack on allowing multinationals into the country, and in favour of promoting domestic capitalists protected against both foreign trade and investment.
Spokesmen from both the Right and the Left seem to be drawing these conclusions, which are also in line with the self-interested positions taken by the Bombay Club. In fact, the correct lessons from East Asia are exactly the opposite.
To understand the Korean system of what has been termed "market governance", it is necessary to go back to the days of President Park Chung Hee, who was the father of the Korean economic miracle. The economic model that was followed was modelled closely on Japan.
As one of the architects of the Korean miracle, the late Kim Jae Ik told me in the 70's, when I was advising the Korean Economic Planning Board, that the famed industrial planning in Korea was very simple. The planners simply promoted those industries that Japan had developed in the early stages of its development.
But once the industrial structure evolves from light to medium and heavy industry the economy needs larger agglomerations of capital. If, as in Korea, there are no such private agglomerations of wealth, a problem arises of maintaining beneficial control over resources because of economies of size. This agency problem in large capital-demanding enterprises can be solved in different ways.
The first is by creating or allowing sufficient concentration of private wealth and some institutional means for it to be spread over a number of enterprises while control is maintained by some concentrated owners.
The second is by allowing foreign equity to control large-scale firms -- the model adopted by Singapore. The third is the state-owned companies (public sector - or better known as PSUs) option -- as adopted by India after Independence in reserving the commanding heights of the economy for the public sector. Given the manifest inefficiency of the latter (because of the problem of incentives), it can no longer be considered a genuine solution to the agency problem.
Korea following Japan followed the first course, as did India in a different form under the spontaneously generated managing agency system during the last 100 years of the British Raj. President Park explicitly said he wanted to create millionaires who would establish large-scale plants to realise economies of scale.
The government's role was to oversee the millionaires to avoid any abuse of power. Thus were the chaebol born, modelled on the Japanese zaibatsu - a diversified business group, whose accumulation was promoted through the provision of long-term subsidised credit.
This carrot was accompanied by the stick, whereby the groups selected for these favours were determined by a ruthless process of allowing the exit of bankrupt and badly managed firms which could not meet the export targets which were used as the monitoring device.
Given that the trade regime provided 'virtually free trade' conditions for exporters, the export success of a group was also a fairly good index of efficiency. With the domestic stock market being moribund, the chaebol remained closely held family concerns controlling a highly diversified set of enterprises. This 'open economy' industrial dirigisme did produce spectacular results.
But as with any form of crony capitalism, corruption was endemic, whose effects on the polity were masked by authoritarian rule. When this began to crack, the extent of the rent-seeking became evident with two of Park's successors in jail.
Also, given the extreme nationalism of the Koreans, virtually no direct foreign investment was allowed, though foreign loans were sought to supplement the high savings rate of the Koreans. The high levels of investment and its relatively efficient deployment because of the 'openness' of the trading regime - at least for exporters - led to Korea's spectacular growth success.
But every now and then, the planners have tried to push the pace with noticeably deleterious effects on the efficiency of investment and thereby on the growth rate.
The latest such attempt was in the 90s, when the investment -GDP ratio was raised from about 30 per cent in the 80s to 38 per cent in 1996. This was financed partly by a rise in domestic savings from about 31 per cent in the 80s to nearly 36 per cent in the 90s, and increasingly by reliance on foreign capital inflows in the form mainly of foreign bank loans to the chaebol, and foreign portfolio investment.
Thus, in 1996, foreign capital flows were 4.9 per cent of GDP, of which portfolio flows were 2.3 per cent of GDP and bank loans 3.0 per cent, the remaining negative balance of -0.4 per cent in direct foreign investment being the investment of Korean multinationals abroad.
The financial crisis arose as a result of a change in portfolio flows in 1997 which became negative (-0.3 per cent of GDP) leading to a decline in overall capital flows to 2.85 per cent of GDP. Meanwhile, as in previous attempts at a form of 'big push' in investment, the efficiency of investment declined.
I estimate using a method due to Maurice Scott that the rate of return on investment declined from about 26 per cent in the 80s to 18 per cent in the 90s. It is this declining profitability which would explain the turnaround in portfolio capital. The chaebol made up some of the difference by increased foreign bank loans: with this type of foreign capital inflow increasing in 1997 to about 3.4 per cent of GDP.
Given a pegged exchange rate which had led to a real exchange rate appreciation with the heightened capital inflows of the 90s, and the non-transparency of the financial system -- a long-term feature of the Korean economy - the stage was set for the crisis which has ensued.
Four lessons emerge. First, is the perversity of maintaining pegged exchange rates in an economy open to capital inflows (unless it is of the currency board variety established in Hong Kong).
The second is the volatility of portfolio capital, which in this sense is less preferable than the direct foreign investment by multinationals that Korea shunned.
The third is the danger of relying on foreign bank lending for domestic investment, particularly if the domestic financial system is as distorted as the Korean - and the Japanese. Fourth, as many of the classical liberal persuasion have maintained, the Korean 'miracle' was largely due to the 'openness' in trade that was used as a monitoring device to keep the chaebol efficient.
This, together with the high rates of domestic savings, allowed it to grow despite and not -- as the 'market' governance' school maintains -- because of its dirigiste industrial policies. The special Asian model of development is as ropy as the corporatist European model now coming unstuck and the failed communist planned system.
The lesson for India and other countries must be that what is derisively called Anglo-Saxon capitalism is the only model of development which is sustainable in the long run, contrary to the assertions of politicians.
In this context, the bleating of India's own version of the chaebol -- the Bombay Club -- is particularly derisory, as they have merely fattened on the rent seeking of a controlled economy and failed to provide the spectacular growth record of their Korean counterparts.
Opening up the economy to multinationals will at last force them to match their performance to their rhetoric or else they will go to the wall. There can be no justification for allowing them any continuing protection against foreign goods or foreign capital. Economic nationalism is the true refuge of the scoundrel.
The author is James S. Coleman Professor of International Development Studies, University of California.
Thursday, March 5, 1998