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This summer, while oecd officials considered Korea's application for entry into the Paris-based organization of advanced free-market economies, huge gaps began to emerge between Korean promises of open financial markets and actual policy. Perhaps nothing highlighted this discrepancy more clearly than the rude welcome home that awaited the record number of Korean tourists travelling overseas this year. Even as mandarins at Korea's ministry of finance and economy (mofe) were busy drafting assurances to the oecd that Korea was committed to unrestricted capital flows, prosecutors in Seoul were engaging in a highly publicized crackdown on Korean tourists who had dared to put more than $5,000 on their credit cards in purchases overseas.
The prosecutors made no secret of having requisitioned confidential credit card records of hundreds of thousands of Korean travellers in order to bring to justice some 15,000 culprits. These may face up to five years in jail for having helped push the country's balance of payments into the red this year, adding perhaps a few million dollars to the deficit.
Korea's balance of payments deficit had surpassed $9 billion by July 29, greater than the total for all of 1995, and the campaign against spendthrift tourists was clearly intended to intimidate travellers from taking any more money out of the country.
To make matters more interesting, the campaign came just two months after the government had unveiled one of many deregulation packages in the financial sector aimed at giving a favourable impression to oecd officials considering Korea's application. That package, announced in May, raised the amount South Korean tourists could take abroad in cash from w3 million ($3,800) to
w8 million. The government apparently did not count on a record number of Koreans going overseas to purchase clothing and household appliances. Because of a highly regulated Korean economy, these are cheaper in neighbouring Japan than in department stores in Seoul. Hence the rush for bargains in Japan not exactly a shoppers' paradise for Americans or eu residents and hence the sudden crackdown on those who violated spending limits.
Such inconsistency in stated goals and actual practice was evident almost everywhere in Korea's financial markets on the eve of the oecd decision and could be seen even in the promises mofe negotiators were handing to their oecd counterparts. For example, although Korea had pledged to open the fund-management market, it turned out that there were huge hurdles for new entrants. Moreover, a "market need" clause would make it possible for Korean officials to turn down any application which, in their view, might lead to disorder in the marketplace.
Likewise, a pledge to open the blue-chip bond market was conditional on the difference between domestic and foreign interest rates narrowing to 2% and interest rates are more or less set by the Korean government. Korean officials would not be pinned down as to when that interest rate differential might be reached.
But deep down the argument between Paris and Seoul was about far more than just corporate bonds. It was about how far the government of president Kim Young Sam would be willing to go in its campaign to bring about what Kim has called segyehwa, or globalization. Successful entry into the oecd was both the symbol and the substance of a highly publicized programme that has sought to bring Korean economic behaviour more in line with that accepted in advanced industrialized nations. This is no mean feat in a country that has an unenviable reputation for closed financial markets, non-transparent regulations, meddlesome bureaucrats, and a generally xenophobic climate.
To make matters more difficult for Kim and his internationalist advisers, negotiations on oecd entry focused primarily on Korea's financial sector which, in contrast to the thriving steel, auto and shipbuilding industries, has lagged far behind foreign competitors in efficiency and profitability.
But that is not to say that financial liberalization would have no impact on industries in which Korea enjoys a competitive advantage. Removing barriers to cross-border capital flows would limit the ability of Korean bureaucrats to influence the won/dollar exchange rate, thus forcing Korean manufacturers to make products that compete not just on price but also on quality, technology and service.
By last month progress had at least been made in obtaining firm assurances on a full opening of the Korean securities market by 2000, and some adjustment of Korean and oecd views had been achieved in negotiations on labour. But in key areas, such as the domestic debt market, serious questions remained. The fact that oecd officials were far from satisfied with Korean assurances was evident from a remark by an official to a Seoul-based correspondent to the effect that "political considerations" would be taken into account when passing judgment on the Korean oecd entry bid.
A challenge to idealism
Moreover, the decision in July of oecd officials not to engage in a third round of negotiations with their Korean counterparts, but to request responses in writing from the mofe to questions, clearly indicated that the oecd was no longer interested in talking. oecd officials wanted to have pledges in writing from the Koreans on how far they were willing to go back on 30 years of protected financial markets in order to gain entry.
It is hard to imagine any application to the oecd for membership, posing more of a challenge to the organization's free-trade ideals than Korea's. Its commitment to free markets is probably one of the most questionable in recent history. Its economic miracle in the late 1960s and early 1970s was created through state-directed allocation of meagre financial resources a process one World Bank report later characterized as "financial repression". In other words, commercial banks were nationalized and turned into cogs in the machinery of what amounted to a command economy.
As for its foreign exchange market, Korea was identified by the us as a "foreign currency manipulator" on three occasions (October 1988, April 1989 and October 1989). Shortly after that us-Korea tiff, the value of the won mysteriously rose by some 25% against the dollar, and Korea's only years of trade surpluses became but a memory.
As recently as two years ago, the Swiss-based International Institute for Management Development found Korea's financial services to be the least free among the 13 Asia-Pacific countries and territories it rated. South Korea's markets ranked at the bottom in seven of 10 categories ranging from "level of market sophistication" to "appropriateness of legal regulation of financial institutions".
On the other hand, Korea has been swept up by the globalization campaign in recent years. At the forefront of the mass movement to harmonize Korean economic practices with those accepted in the advanced industrialized world is none other than president Kim, who as early as 1992 put oecd entry on his election platform. A month after becoming Korea's first civilian president in 35 years in March 1993, he outlined his vision for a new Korean economy. The cornerstone of the domestic part of what was dubbed the New Economy package was the elimination of unnecessary regulations and the reining in of the arbitrary powers of bureaucrats. Membership of the oecd, an organization committed to the free market, would be a fitting complement to Kim's vision.
Even though Korea clearly lags behind other countries in the openness of its capital markets, Kim and his advisers have at least opened a few doors in the past two years. For example, the limit on foreign ownership of Korean stocks has steadily been raised from an initial 10% in 1992 to 18% as of August this year. mofe officials have promised to eliminate the ceiling on foreign equity ownership altogether by 2000.
Naming names
Perhaps Kim's most dramatic effort to eliminate arbitrary non-transparent market behaviour came on August 13 1993 when he issued a declaration abolishing "false name" financial transactions. Hitherto, the government had looked the other way while thousands of wealthy corporations and individuals (often corrupt politicians and officials) put their undeclared funds into the stock market and into the semi-legal high-interest loan market based in Myongdong, Seoul's entertainment district. The flow of illicit funds into these two markets had been the result of distortions caused by over-regulation: as, for example, in the case of the huge bribes that bank presidents in Korea regularly accept in order to bend government regulations limiting the allocation of loans.
Kim's introduction of a "real name" financial system has largely been a success. Although the stock market initially plunged, after undeclared funds invested in false name accounts suddenly left the market, within a few weeks the index recovered as ordinary individuals realized the potential benefits of more transparent practices.
Later that same year Kim unveiled his segyehwa campaign. In short, he urged Koreans to wave goodbye to economic nationalism and say hello to the fact that Korea needs the world more than the world needs Korea. Segyehwa countered the fact that while economic nationalism may have helped Korea pull itself up by its bootstraps, the xenophobia it fostered also discouraged foreign investment.
Moreover, as government officials explained, an absence of foreign investment meant an absence of technology transfers. Korean labour costs were rising (thanks in part to the return of the military to their barracks), and the country had high interest rates (thanks in part to the huge volume of non-performing loans banks had been saddled with during the days of financial repression). So Korea had no choice but to open its doors to foreign investment and foreign technology, without which Korean products would be unable to compete successfully in overseas markets.
It was because of segyehwa that government officials, such as Ha Dong-man, a division director in the former Economic Planning Board, could alert Koreans to the effect that restrictive policies and a hostile domestic climate had on foreign investment in Korea: it amounted to a mere $5.5 billion between 1988 and 1992, compared with inflows into China, Malaysia and Thailand which in the same five-year period had totalled $87.6 billion, $24.7 billion and $30.4 billion respectively.
But just in case the importance of segyehwa was missed by the general public, the government for the first time took steps to make ordinary Koreans aware of the strongly critical feelings of foreign business people about working in Korea.
One example was a government-commissioned survey, the results of which became the lead front-page story of the Choson Ilbo, South Korea's largest daily. Of the 349 American, Australian and European resident business representatives surveyed, 47.1% singled out "various government regulations applied to business" as the most trying aspect of working in Korea. The next largest group rated xenophobia, both in business and in ordinary life, the biggest hurdle. Perhaps not surprisingly, the survey quoted a majority of respondents as requesting president Kim to genuinely internationalize the Korean economy.
Though the survey might smack of a government campaign, segyehwa has served the interests of international business and finance far better than previous government campaigns, which had urged Koreans to stop smoking foreign cigarettes, refrain from spending lavishly on weddings, and generally lead frugal lives. Invariably frugality meant staying away from "foreign luxuries". One form of quasi-legal discouragement consisted of sudden tax audits of anyone with a taste for foreign cars. This resulted in wealthy Koreans removing the numerical designation badges from their Mercedes-Benz cars, or else having the numbers modified downward so that a Mercedes 600 series would be disguised as a Mercedes 320.
A cap on xenophobia
Segyehwa also put an end to spontaneous outbursts of anti-foreign activity. For example, when us film distributors attempted to import Hollywood films in the late 1980s for the first time, Koreans opposed to foreign participation in the film market released snakes in crowded cinemas. Likewise, managers of Control Data, an American electronics manufacturer, were forcibly held by Korean employees until they gave in to wage demands. Control Data was among a number of foreign companies that closed their factories in Korea, never to return. Since the government's segyehwa campaign, no such anti-foreign outbursts have been reported.
Seen in this light, president Kim has been nothing less than an internationalist. Indeed, at least one official has argued that for the oecd to refuse to accept Korea as a member now would be to humiliate Kim and to turn the clock back to an unpleasant past.
On the other hand, there has been plenty of room to raise serious questions. Korea's suddenly deteriorating balance of payments had clearly made Korean policymakers at all levels more cautious about free capital flows. As Song Hee Young, business editor of the Choson Ilbo, puts it: "Koreans see entry into the oecd as evidence of having gained advanced-country status. The problem is that right now we are headed into a recession. So some people want to slow the entry process down."
If evidence was needed for this change of heart among the Korean elite, there is plenty of it in the form of imaginative doomsday scenarios linked to Korea's oecd entry. For example, if Korea were to accede to the wishes of the oecd and fully open its financial markets, the sudden influx of foreign funds would be so great as to trigger a financial crisis of the magnitude that shook Mexico in December 1994.
As Shim Sang Dal, mofe's chief spokesman puts it: "There are people in Korea who see Mexico as an example of what can happen to a country when money is allowed to enter and leave quickly. If the fundamentals of the economy are not sound, the process weakens competitiveness." (This refers to short-term portfolio investment South Korea has a 30% plus savings rate, and most overseas borrowings are long-term bank loans.)
For those afraid of a confrontation with North Korea, if the South Korean government were to accede to the liberalization demands of oecd negotiators, it would be surrendering important fiscal tools necessary in the event of a national emergency. It is argued that foreigners, unlike patriotic Koreans, will not hesitate to pull their money out of Korea quickly should communist North Korea threaten national security in the future. As mofe spokesman Shim puts it: "The government has been cautious for both fiscal and geopolitical reasons."
Finally, there is the Japanese version of doomsday. This envisages the inflow of foreign funds precipitated by the opening of Korean financial markets leading to a high won, which would then usher in years of spiralling domestic land and stock prices. And, like the Japanese bubble, the Korean version would soon burst, leaving the economy in a shambles.
The doomsday scenarios all have something in common. They focus on the single-most serious gap in thinking between the oecd and Seoul, one that is likely to remain unresolved for years, regardless of which way the oecd votes. The bone of contention is the blue-chip bond market.
Paralleling the bond market, and equally significant for foreign financial institutions, is the present ban on foreign borrowing by Korean corporations. Since the late 1980s these have been barred from borrowing abroad (except when engaged in overseas projects) and Korean banks must obtain official permission before obtaining a loan from a foreign bank. This is in spite of the fact that Korea's industrialization was achieved through direct foreign bank loans, which at one time reached almost $50 billion,
The reason for such a cautious approach to investment comes from the fear that huge and sudden inflows of foreign capital will result in a rise in the value of the won and that exchange rate instability will destroy Korea's export competitiveness.
Bond warnings
Perhaps the most eloquent spokesman for Korea's cautious approach to opening the bond market is Cho Yoon Je, a former World Bank and imf economist, at present a senior fellow at the Korea Institute of Public Finance. To begin with, Cho stresses that Korean corporate bonds are guaranteed: "If you allow risk-free Korean bonds to be bought by foreigners, you are giving them an opportunity to make arbitrage windfalls."
As of early August the yield on blue-chip corporate bonds stood at 12.36%. Corporate bond yields have been rising because of a 37% decline in the profits of Korea's listed companies a 55% decline in the key manufacturing sector. Korean corporations are heavily leveraged and need to borrow in both good times and bad. (In this same period, the us treasury bill rate stood at just above 5%.)
A peculiarity of the Korean corporate bond market is that some bonds are issued with stamped bank guarantees. Recently, when a Korean construction firm was on the brink of bankruptcy, it was the shares of its main bank, not the firm's own shares, that took a beating on the stock market. If the construction firm were to become insolvent, the bank would have had to reimburse the firm's bondholders. Cho stresses that if, as the oecd has apparently insisted, South Korea fully liberalizes its bond market, investors from all over the world will make a mad rush for such corporate blue-chip bonds.
"There are many things the government can do," says Cho. "If they do nothing, the sudden inflow will increase the money supply, which then will result in inflation. In response the Bank of Korea can buy up the domestic liquidity by issuing stabilization bonds."
But Cho argues that such constant mopping up of funds would result in a vicious circle in which domestic interest rates would continue to increase and foreign funds would just keep on coming in.
"Already about w30 trillion worth of stabilization bonds have been issued," says Cho. This amount is more than the total monetary base of the country (cash in hand plus deposits from Korean banks and banking institutions at the Bank of Korea.)
The government does have another option, according to Cho. To help control inflationary pressures, it could opt for strong fiscal restraint, but public investment is badly needed. "The government cannot stop spending now because the country is facing severe social infrastructure bottlenecks," says Cho. He points to the SeoulPusan freeway on which it used to be possible to travel between the country's two main centres in six hours: "That trip now takes 10 hours."
Korea's harbours are also inadequate, leading to increased costs of exports because of the long waiting time for ships to be loaded and unloaded. There is little room to make cuts, so Cho advocates "gradualism in the opening of the debt market".
Crumbs from the table
In August, it was difficult to know if oecd negotiators would be swayed by arguments such as those offered by Cho, one of a number of economists who have close connections with Korean officials negotiating with the oecd. One thing is certain: in Seoul representatives of foreign securities houses were less than amused by what they saw as "crumbs" being thrown to them in a recent series of measures ostensibly designed to open financial markets to them.
In the corporate bond market, for example, mofe officials have pledged to raise the ceiling on unsecured and non-guaranteed corporate bonds issued by small and medium-sized Korean firms from 30% to 50%. This part of the bond market is high in risk and low in liquidity, and hence not very popular with investors of any nationality.
In Seoul, where government regulation of both domestic and foreign financial houses is all-pervasive, it is difficult to find many financial market players willing to go on record criticizing the policies of mofe officials. Nonetheless, there is no shortage of privately voiced dissatisfaction over one particular market-opening package aimed clearly at satisfying formal criteria for oecd membership. In November 1995 mofe announced a plan to open the money management field to foreign companies. In the view of one foreign securities analyst, however, the package was "an opening in name only". Eligibility requirements for 100% foreign-owned investment management businesses included "assets under management totalling the equivalent of $18 billion".
Questioned as to why such huge qualifying requirements were to be imposed solely on foreign firms, mofe spokesman Shim replied: "That is to insure that only companies with good financial standing will come."
But the foreign analyst also points to the requirement that foreign fund management companies spend $6 million in operating expenses yet another hurdle set up to discourage foreign financial houses from setting up shop in Seoul.
"The purpose of the package is to help foreign fund managers come to the conclusion that it is cheaper to make a few visits a year to Seoul than to stay around," says the analyst. This same package also called for a "needs test": the criterion for which would not be disclosed, but it would be administered by mofe officials. Apparently as a result of foreign pressure, the government dropped the words "needs test" and promised a new criterion to be announced later.
If the sticking points in the negotiations with the oecd have tended to focus on finance, it is because the financial sector is without a doubt the most underdeveloped part of Korea's economy, and one that suffers most from the crippling legacy of past industrial policy.
Even though Korea today has an economy that is the 12th largest in the world, is the world's 13th-largest trading nation, has the world's fifth-largest car industry and the largest backlog in shipbuilding orders, it does not have a single bank which is rated among the top 100 in the world.
A World Bank discussion paper published just last year points to other weaknesses in the financial sector. It states that in the long period when Korean banks were under government control "their managerial efficiency and the quality of their services were sacrificed".
Black market skills base
Karl Moskowitz, a Seoul-based management consultant, has drawn attention to the fact that in its heyday Myongdong's black market in money was considerably more advanced in credit-rating skills than Korea's commercial banks: "It is the only debt market in Korea where credit decisions and risk premiums are based on creditworthiness and the likelihood of repayment, not on fixed-asset collateral or guarantees a skill the commercial banks have yet to display."
Moskowitz praises the resourcefulness of the private credit bureaux in Myongdong, whose staff "obtain information from the records of commercial banks, tax offices, and similar confidential sources through informal methods".
In contrast, South Korea's major banks are classic cases of overemployment and inefficiency. Moreover, South Korean labour practices make it extremely difficult to dismiss surplus employees, and so mergers cannot be counted on to bring about increased efficiency.
To make matters worse, rivalry between the government and Korea's huge business conglomerates, the chaebol, has resulted in the passing of legislation aimed at preventing any Korean bank from being taken over by a chaebol.
There may be understandable social reasons for a bank being prevented from falling into the hands of a large capital-hungry conglomerate. But the result is that once Korea has truly been integrated into the oecd, relatively weak Korean banks whose average efficiency has been rated at roughly half the level of the typical Swiss bank will have to be able to fend for themselves in an increasingly sophisticated and highly competitive open environment.
The fact that mofe negotiators have made no attempts to protect the banks from the foreign competition that is likely to arise might just indicate that somewhere in the bowels of the mofe building there are Korean officials who really would like to see a part of their country's financial industry gain strength through open competition.
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