A package of problems

The IMF policy package for South Korea can give rise to a sharp increase in unemployment in a country least accustomed to it in recent times and this can lead to a domestic political backlash.

IN its game of creating crises and resolving them in its favour, international finance faces new obstacles in East Asia. For one, unlike in the case of Mexico, the engineered crisis here is far more serious. The extent of the currency collapse in these economies and the magnitude of the 'bail-out' packages, rising from $17 billion in the case of Thailand to $57 billion in the case of South Korea, are indicators of how severe this crisis is. As a result, the International Monetary Fund's (IMF) task of convincing the atomistic agents of international finance of the reliability of its prescriptions for a revival of these economies becomes all the more difficult.

The country where this comes through most clearly is South Korea. Most observers admit that the crisis in South Korea is far less a crisis of the real economy than of its financial sector. Given the crucial role of finance in driving the export-led expansion of South Korea, most business groups (chaebols) were heavily in debt. This in itself would not have been a problem if all investments were as successful as the South Korean economy itself. In practice they were not, but in periods of high growth most business groups were in a position to cross-subsidise their loss-making operations with revenues from their more profitable ones.

Two developments have adversely affected this arrangement in recent times. First, a slowdown in international trade growth in general and in trade expansion in certain areas such as semiconductors, office automation equipment and consumer electronics undermined this ability of the hugely diversified chaebols to cross-subsidise their activities. Second, in order to continue to prop up these large organisations, banks used the benefits of a liberalised financial environment to borrow heavily from the international system and disburse those funds domestically. This included in recent times a large volume of short-term commercial borrowing from abroad. According to official figures released by the Finance Ministry, as of December 20 South Korea's total external liabilities totalled $153 billion, of which $80.2 billion consisted of debt maturing within a year. Clearly, it was not merely South Korea's banks that were not diligent about their exposure; the international financial system was also to blame for this.

It took a slowdown in export growth to spur international financial uncertainty about the prospects for repayment of short-term debt, which resulted in the growing unwillingness of banks to roll over short-term debt. In a liberalised financial environment, the first effect this has is on the value of the domestic currency that begins to slide. This has two consequences: it sets off a speculative attack on the currency from traders looking for quick returns; and it encourages domestic banks that have to make dollar payments to service their short-term debts to rush and purchase dollars. A collapse of the currency follows. Accompanying that is a slump in the stock markets where institutional investors who have made large portfolio investments lose confidence and book profits and withdraw.

DEALING with such a situation requires action in three directions. The first is to stop the slide by organising the wherewithal to meet immediate foreign exchange commitments. The second is to ensure that the growth of the real economy is not affected, so that a financial crisis does not trigger a deep real crisis. The third is to prevent the profligate use of foreign exchange by private banks and corporations which do not themselves generate adequate foreign exchange, so as to limit the country's external vulnerability.

The IMF-negotiated 'bail-out' package does seek to realise the first of these objectives. The IMF released $10 billion soon after the Government met some of the principal conditions associated with the rescue package. It also urged bank consortia in the United States, Europe and Japan to agree to a rollover of short-term credit and to provide fresh credit. But the IMF's package militates against the realisation of the last two of the policy prerequisites mentioned above. By demanding that the Government should not step in to rescue banks, financial institutions and firms that are threatened with closure, the IMF is enforcing a deflation, which is reflected in the demand to scale down growth targets in the short term. The IMF has also made its package conditional upon substantial liberalisation of financial markets, which allows for a sharp increase in foreign presence in these areas. The financial reform enforced by the IMF gives greater independence to the central bank in setting monetary policy, opens the bond markets fully for foreign investors, lets foreigners acquire up to 55 per cent of listed companies and opens the stock market in full to foreigners by April 1. It is argued that this strategy will restore investor confidence and result in a revival of foreign capital inflows. That is, the idea is not to reduce the external vulnerability associated with foreign capital inflows, but to try and attract more of such capital in the short run irrespective of its implications for vulnerability in the medium and long term.

There are a number of problems such a policy package gives rise to. First, since it involves a sharp increase in unemployment in a country least accustomed to it in recent times, it can lead to a domestic political backlash. It will not be easy for a new 'opposition' government, due to take office soon, to resist such a backlash. Pushing through the typical IMF-style adjustment package in the current situation heightens political uncertainty. Second, growth in South Korea and other East Asian economies would decelerate sharply under IMF tutelage, and its adverse repercussions are bound to be felt in the developed industrial world as well.

IN a special update to its World Economic Outlook, published on December 21, the IMF, which had earlier predicted the strongest growth rates of the decade during this year and the next, scaled down projections across the board. The growth forecast for South Korea is down from 6 per cent to 2.5 per cent, for Thailand to zero per cent, and for Malaysia to 2.5 per cent. The effects on world growth of such low growth rates in the most dynamic economies of the early 1990s would be severe both because imports into these countries would fall and because currency depreciation would make their exports more competitive. Even as early as November 1997, imports into South Korea fell to $11.4 million compared to $12.81 billion in November 1996. The factor driving this decline was a 25 per cent fall in capital goods imports in November as against a 19.2 per cent rise a year ago. The effects of deflation are obvious. On the other hand, exports rose from $11.52 billion a year ago to $12.07 billion in November 1997. Even the optimistic estimates of the IMF suggest that such trends would result in a reduction of world growth by 0.75 percentage points. This makes growth in the member-countries of the Organisation for Economic Cooperation and Development (OECD) close to between 2 per cent and 2.5 per cent. As this scenario unfolds, a protectionist backlash in the OECD countries seems inevitable.

The combination of a potential political backlash in Korea and a protectionist backlash abroad has substantially increased uncertainty in international financial circles. Not surprisingly, on December 22, after the IMF package had been clinched, Moody's downgraded the ratings for government and corporate bonds, including those of 20 banks, to junk bond status. Bankers from the G-7 countries who gathered at emergency meetings over the Christmas holiday week reflected that rating. While hesitantly agreeing to roll over for a month $15 billion of credits due by the end of the year, most of them expressed unwillingness to share in the over-exposure of a few banks by making new advances.

On the surface this should not necessarily be an insurmountable problem. November 1997 was the first month since December 1993 when South Korea posted a current account surplus of $554.7 million. However, capital outflows resulted in a capital account deficit of $2 billion, and a consequent fall in reserves. This compares with the situation a year ago when in a reverse situation the capital account recorded a surplus of $1.3 billion, while the current account registered a deficit of $2.07 billion. The task is to strengthen the ability to finance capital outflows with a minimum of new borrowing and not to liberalise markets to try and trigger another round of excessive reliance on foreign inflows. This requires greater control over private financial flows rather than their further liberalisation.

But if the IMF chooses that track it would be asking transnational banks to agree to a rescue package to atone for their own profligate lending in the past, which restricts the extent of misinformed lending and investment they can indulge in future. This is not to be. Rather, the banks and financiers are being rewarded with greater access to South Korean markets in order to coax them into preventing a default of their own debt. This is clearly a strategy that privileges international finance. But the effects of that on the real economy worldwide can well prove counterproductive.