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A quarterly magazine of the IMF	June 2007, Volume 44, Number 2

Point of View

Back in 1997, the Asian financial crisis seemed like it was primarily a liquidity problem—at least in Korea, where the monetary authority had to struggle by the hour to prevent foreign exchange reserves from drying up, until Korea was saved by a huge loan from the IMF. If that's the correct diagnosis, then the affected countries may be said to have learned more than their share of lessons.

First, their foreign exchange reserves are now at much more comfortable levels than before the crisis. For example, since August 2001, when Korea finished paying back the IMF the money it had borrowed during the crisis, it has accumulated foreign exchange reserves of more than $240 billion—a dramatic improvement from a meager $7 billion in 1997. Second, the earlier problem of "overinvestment" in Asian countries no longer exists. Investment rates have fallen and net exports have climbed, helped by the drastic depreciation of some Asian currencies during the crisis. Third, the macroeconomic picture in Asia is now bright. Again using Korea as an example, nearly all macroeconomic indicators look quite robust: GDP growth rates fluctuate around 4–5 percent—not bad for a country whose GDP per capita is approaching $20,000 a year—inflation is below 2.5 percent, and the unemployment rate is below 4 percent.

However, despite what the macro figures imply, it is not very clear whether the Asians who went through the financial crisis are truly better off. In Korea, many people feel that their quality of life is worse now than it was before the crisis. Nor do the nice macroeconomic numbers automatically translate into happiness for ordinary people. This discrepancy raises the question of whether there has been a fundamental change in Korea's economic structure since the crisis. To determine that, we need to look at both the financial crisis itself and the events before and after as part of a structural problem instead of as a simple liquidity problem.

Looking behind the numbers

Before the financial crisis in Korea, the main players in the country's economy, including financial institutions, large conglomerates, and the government—also known as "Korea, Inc."—formed a kind of huge risk-sharing system. But it was a system that incorporated fatal problems. Korea's large conglomerates comprised numerous seemingly independent companies that were interlinked through a web of affiliations and cross-payment guarantees. Their profits were often overstated because of the internal transactions taking place among them. And, in the case of financial institutions, the scale of bad loans was underestimated because nonperforming loans excluded substandard loans.

Policymakers refused to admit the difficulties that the Korean economy was facing and, instead, continued to insist that the nation's economic foundation was sound. In such an environment, moral hazard was prevalent among nearly all economic players—including private enterprises, financial institutions, workers, and depositors—mainly because society believed that all of its losses were implicitly guaranteed by the government. Indeed, the government implicitly or explicitly forced financial institutions to guarantee large conglomerates against risky investments, and any burden of loss was covered by the entire nation. It is quite obvious that such behavior was incompatible with the forces of globalization. Admittedly, however, it was also an easy way to create jobs and maintain economic stability.

The problem is that such a risk-sharing system becomes increasingly incompatible as the economy grows bigger and more complex. This is even truer in a globalized environment. In a sense, such a gap between local and global standards reflected an unwillingness to adapt to globalization. It was only when faced with a crisis that the Korean economy was forced to adapt.

Adopting painful measures

After the IMF and the international community stepped in with big loans, Korea had to adopt painful measures to bring things back under control—including tight monetary policies; stringent government budgets; a free-floating exchange rate system; financial sector restructuring, with nine banks merging to form four successor banks in two years; tightened prudential regulations; and enhanced transparency of financial information.

These policy measures had a powerful impact: the economy not only recovered but underwent a major transformation. For example, banks and big businesses are no longer 100 percent protected, and none of them harbors the deluded perception that it is "too big to fail." However, this is not a story with an entirely happy ending.

With its sound macroeconomic numbers and more globalized standards, the Korean economy should by now resemble an advanced one more closely. But instead it suffers from polarization and increased inequality. House prices have gone up dramatically, pricing some people out of the market. In addition, even 10 years on, most self-employed people have been unable to recover their precrisis living standards. In fact, it was these very people, the ones with fewer resources, who bore the brunt of the pain of change and restructuring. This, in turn, hampered the growth potential of the economy, as human capital was eroded in the middle- and lower-income groups.

Therefore, although it is true that the financial crisis is over, the economy is still forced to adjust to internal and external changes, and pain is still felt by those not fortunate enough to share the benefits of recovery.

New compact needed

The heart of the problem in postcrisis Korea lies in the fact that, although the old way of doing things was ostensibly swept away, a new structure has not really evolved to replace it. For example, while Korean companies try to formulate their plans according to global standards, their interactions with one another and with their environment are still rooted in the old ways of doing business in Korea.

Globalization has also brought with it a more hard-nosed attitude by business that has reinforced the sense of polarization in society. For example, since the crisis, a conservative attitude and an emphasis on short-term profit may have raised the soundness of banks, but have also hurt the development of small and medium-sized companies that lack adequate collateral. Understandably, banks feel more comfortable lending against real estate rather than against business plans or the say-so of individuals. This, in turn, has shrunk a potential source of wealth for banks. As a result, the scenario resembles an inferior Nash equilibrium in which, eventually, everyone loses—not what we want from a globalized economy.

How has the Korean economy slipped into this unsatisfactory position? The main reason, it seems to me, is that Korea lacks an effective common understanding about how things should be run in this new era.

As we have seen, before the crisis, Korea had its own unique business culture epitomized by the triangle consisting of the government, financial institutions, and big conglomerates. This overarching structure of Korea, Inc., has been destroyed, in part by the crisis and in part by an inevitable process as the economy grows larger and becomes increasingly exposed to the wave of globalization. However, right now, while the old system no longer works, the Korean economy seems to have no firmly established mechanisms through which individual actions can be coordinated and risks can be managed in a way that is compatible with the global standard.

In my view, a new social compact must be established if the globalized system is to achieve success in Korea—and, perhaps, in other Asian countries as well. In a sense, one can regard an accepted ethos as similar to tacit knowledge. Although global standards that work well in affluent nations can be exported to developing countries, in many cases, the invisible or seemingly unrelated parts that form the basis of well-functioning global standards are neither readily available nor easily transferable. For example, one can easily see that social safety nets that mitigate workers' fear of restructuring, the trust and reputation that facilitate market transactions, and the legal systems that support markets are not easily exported to developing countries.

The potential role of this invisible but important part of human interaction should not be underestimated. The social capital of trust, an accepted long-term view, and shared norms that generate a positive environment for everyone are needed to ensure transparency and to guarantee that market principles work properly. Without accepted norms of operating, the law of the jungle will win out over a regulated market economy, reinforcing the position of economically powerful agents over that of less powerful ones.

Although it will take a long process of trial and error to build a well-balanced economy supported by an overarching set of accepted economic and social norms, political leadership can do a lot to improve things in the meantime, especially in the area of conflict management between the winners and the losers in these changing times.