History Of Asian Economies Essay, Research Paper

Korea was one of the poorest countries in world after experiencing two wars.

World War II and Korean war (1950 ~ 1953). The country even experienced a food

shortage so that it had to heavily rely on the foreign aid. Yearly per capita

consumption was a mere $88 as late as 1965. However, since 1965, Korea has been

transformed from its underdeveloped agricultural economy to a leading Newly

Industrializing Country. Between 1965 and 1981, its gross national product GNP

multiplied twenty times from $3 billion to $63 billion and per capita GNP

increased sixteen times from $88 to $1,554. There have been many explanations

for Korea?s successful story. Among those, the strong role of government would

be probably the most important one. At the same time, this would be also

responsible for current recession. After Koran war, the government in fact had

no sense of direction and also due to the unstable political situation, the

country didn?t have specific economic policy until 1961 when military

government came to power and established the major institution guiding its

economic planning called Economic Planing Board (EPB). This government set

economic development as the top national priority and recognized the financial

system in support of economic development plan. To achieve this purpose, it

focused its policies mainly on export expansion moving its emphasis from import

substitution. The result was considered quite successful for economic growth.

Between 1965 and 1973, exports grew at average annual rate of 45%, from $175

million to $3,271 million. The success of the expansion was due primary to three

factors (Kwack, 72). The first was a favorable international economic

environment, which saw total world imports expand from $175 billion in 1965 to

$536 billion by 1973. This boom in imports of the world reflected the fact that

the industrialized had not yet erected import barriers against exports from

developing countries and were, on the contrary, quite active importers of

cheaper goods from Newly Industrializing Countries such as Korea. A second

significant factor was the Korean government?s policy of promoting exports,

which was set in motion in 1965. Initially, the government introduced a number

of fiscal and financial incentives, which I will discuss more later. A third

factor was Korea?s abundant and highly productive labor force. This gave Korea

a strong comparative advantage in producing labor intensive products and

provided the impetus for the notable expansion for exports. In order to expand

total exports over time periods, however, Korea turned to new export industries

that were expected to have a comparative advantage with abundant labor, but

skilled labor at this time, such as shipbuilding, electronics, and steel

industries. This attempt was viewed as a manufacturing shifting of its emphasis

from light industries to heavy industries which later started to produce

intermediary goods as substitutes for imports (Kwack, 77). However, this

government?s promotion of heavy industries for large-scale economies led to

under-investment in light manufacturing industries causing productive gap

between small and large firms. Actually, the large firm that runs heavy

industries has been given priorities, and small and medium firms relatively

disregarded in government?s allocation of loanable funds and other

administrative preference. As a result, conglomerates later known as chaebol

(family owned conglomerate) have been formed through this expansion of heavy

industries. Government?s Policy Before 1961 As seen above, the Korean

government has been focused on import substitution for economic growth during

1953 ~ 65 period and followed by export expansion policy after 1965. However, to

progress its policy efficiently, the government had to face to one of serious

problem, poverty. After two major wars, the country even with a food shortage

experienced lack of capital. There was no source for savings and investment to

finance economic growth domestically, so it depended heavily on foreign capital

which inflow in a form of mostly aid and loan in the early stage of economic

growth. The proportion of foreign capital to total capital formation in 1965 was

approximately 40 percent. In addition to inflow of foreign capital, the

government faced allocation of capital with using its financial system. Before

the military government in 1961, the loan decisions of commercial banks were

heavily influenced by political interference (Haggard, 26). Well, in fact the

loan decisions in Korea mostly were affected by political interference rather

than bank themselves until recent time, but during the 1948 ~ 1961 period, the

rent generated by low interest rate was used for its political activities rather

than economic growth. Government?s Export Promotion Policies In the economic

development, the government?s creation of economic rent for certain segments

of business takes critical role. It can be either a source of political and

bureaucratic corruption, but if wisely used, it can be a useful or powerful

policy instrument in supporting business operation and government policies.

Furthermore, it can increase capital formation in the country if it effects a

redistribution of income from consumption to investment activities (Haggard,

23). Since the mid 1960s, the military government used regulated finance as one

of tool to create rent and achieve exports expansion. What it did were

nationalizing commercial banks and amending the Bank of Korea so that it can

control financial systems directly. In general, the Bank of Korea, in its role

as the country?s central bank, determines the allocation of loans, interest

rate level and the supply of money but the decision making in these area is

controlled by the Minister of Finance. In other words, it was government?s

responsibility generating monetary and fiscal policy, not by the central bank.

Since foreign aid started to decline later 1960s, the government reformed

interest rate. It raised the interest rate on (one-year) time deposits from 15%

per year to 30% per year and general loan rate from 16% to 26%. The reform

successfully attracted private saving. In the first three months after reform,

saving deposits increased by 50%. More importantly, this meant more rent, in

other words, more capital to be distributed under government influence. In

addition, the financial reform contributed to a massive inflow of foreign loans

due to the existence of gap between domestic and international interest rate and

since the Korea Development Bank guaranteed to pay back to foreign lender, the

inflow of the loans were accelerated. Also this gap of interest rate was used to

promote export expansion which was the most economic priority. For example,

while domestic interest rate was so high comparing with international rates, the

exporters, mostly big business in heavy industry, were able to get loan at

little interest rate. They were not only able to get low interest rates, but

variety of supports that the government could do such as tax break and easy

approval of the loans for exporters. For example, profits earned on exports have

been exempt from corporate or individual income tax and the short-term export

credit system gave borrowers holding export letters of credit (L/C) ?automatic

approval?. As a result, an increase in domestic savings and huge inflow of

foreign borrowings had positive effect on economic growth in Korea due to an

increase in capital accumulation. Controlling exchange rate is another good

example to describe the effect of government?s role on Korean economic

development. After switching its economic policy from import substitution to

export expansion in the mid-1960s, the Korean government officially moved from a

fixed parity to a unitary floating exchange rate system. Although the exchange

rate system has been ?floating?, its actual (real) rate was managed by

government?s market control and Korean currency ?won? was undervalued

mostly against the U.S. dollar so that the price of exports remain cheap.

Followings are the plans that the Korean government set over time period as a

guide for economic growth. They are quite helpful to understand how major

government?s policies on financial sector have been varied with given the

world economic situations like oil crisis and its own economic recession. The

First Five Year plan (1962 ? 1966) The first plan was prepared in a hurry by

the military government that took power in 1961. The major contents of fiscal

and financial policies as stated in the plan document were largely about the

tax, budget, and monetary system, financial market and foreign exchange system.

During this period, its main purpose was, however, to expand exports as much as

possible by providing export firm with cheap loans, tax benefits, export

compensation schemes, and various administrative support. Economic growth in

this period was result by an increase in export and output and as well as price

level (since output and price level are positively correlated), so there was

inflationary pressure at the end of the first plan- actually the inflation rate

exceeded 23 percent in 1964. The Second Five-Year Plan (1967 ?1971) During

this period, the major reforms include a financial reform assuring positive

interest rate in 1965, and exchange rate reform normalizing highly overvalued

exchange rate, and trade reform allowing wide imports of parts and machinery

used for the production of export goods. These reforms were reflected in the

second plan and carried further throughout the second plan period. In addition,

there was an increase in domestic savings and a decrease in foreign borrowing.

The Third Five-Year Plan ( 1972 ?1976) The third five-year plan put its major

emphasis on the promotion of heavy and chemical industries. The government made

great effort to raise domestic savings to finance the heavy and chemical

industries, but the amount of domestic savings fell far short of investment

requirement. As a result, foreign borrowing expanded enormously, and management

of foreign borrowing and debt became a major policy issue. In addition, due to

different emphasis on light and heavy industries, the growth gap increased

substantially. Inflation caused by the first oil shock in 1973 also takes a part

of unstable situation of economy. Inflation rate exceeded 40 percent in 1974.

The Fourth Five-Year Plan (1977 ? 1981) Because of high inflation cause by the

first oil crisis, stability was given relatively high policy priority. The

government adopted monetary rule of fixing money supply growth at a prescribed

constant rate of 20 percent per annual to stabilize price level and overall

economy. He major change in trade policy during the fourth plan period included

the expansion of imports related to exports, maintenance of effective exchange

rate, expansion of export subsidies, tax benefits and foreign loans to export

firms. In addition, the government improved the number of industrial estates for

export firms by creating industrial export estates and free export zones. The

fifth Five ? Year Plan (1982- 1986) In the early 1980s, the Korean economy was

characterized by very slow growth rapidly expanding foreign debt, and high

inflation. Consequently, export promotion was given the highest policy priority

again, so the major change in trade policy included intensive promotion of

export goods and market diversification, reform of the export support system,

lowing tariff rates to expand importation of good used in manufacturing. The

Sixth Five year Plan (1987 ? 1991) As of 1986 the Korean economy realized high

economic growth, stable price, and a trade surplus and thus faced a new phase of

growth with enhancing the efficiency and strengthen the international

competitiveness of the Korean economy in general by reforming the free

enterprise market system. Thus the major contents of policy reforms included the

dramatic reduction of various government regulations constraining growth of

enterprises plus extensive promotion of liberalization of finance, imports and

foreign exchange. The Seventh Five ? Year Plan (1992 ? 1996) This plan was

formulated after Korea became a member of the United Nations and emphasized the

role of private sector in preparation and implementation of the plan. The Eighth

Five ? Year Plan (1993-1997) The preparation of this plan started with the

beginning of the Seventh Republic and the plan emphasized that management of the

economy will no longer be government led or government controlled, as in the

past, but will be based on the participation and innovative spirit of the Korean

people. It also stresses the importance of reform of finance, government

administration, budgets, ethics, etc. Even though the government on each period

recognized the problems it was facing and made five-year plans, they were not

always successful. Throughout the plans above, we will be able to find a common

policy used without difficulty. That is the government?s massive supports

toward export firms. It must work during the early stage of development when the

country had little capital accumulation. However, the government?s unbalanced

incentives on big businesses which are mostly in heavy and chemical industries,

later known as chaebol, actually led them to depend too long on protection and

debt financing. This policy wasn?t a serious problem when the economy boomed,

but when it slowed, most debt ridden firms fell back on the government for

relief causing the issue whether the policy and the industry are efficient or

not. (Haggrd, 24). For example, the combined sale of the five largest big

companies, chaebol, take 37percent of Korea?s gross out, and their exports

were 44 percent of total exports in 1997. If there is a little slow down of the

one of the largest business, then it is obvious the economy is not in quite safe

situation. Since chaebol?s share of Korean economy is already huge, if they

are allowed to fail or banks are to write off their debt, then the whole banking

system would be pushed into collapse. This is real problem, nor chaebol or their

associated companies, be easily shut down (Economist). As a example, the price

of a 16 MB dynamic random access memory (DRAM) chip fell from more than US $40

in January 1996 to less than US $10 by the end of 1997. The dollar export price

index for Korea?s electronic components fell by 50 percent over the same time

period. Another example is current collapse of Daewoo, a second largest chaebol,

which had huge debt to equity ratio (over 400 percent), went to a bankruptcy

this year. This company was well known with a very close relationship with the

governments in the past. It was ironic to see that Daewoo was expanding its size

when the country was in recession and other chaebols tried to reduce their size

and increase efficiency. Actually, this is not the first time Daewoo asked for

the government?s help. Every time the company went into a trouble, the

government didn?t let the company to fail and put more capital available into

the company. However, this time it doesn?t seem happening that way. Actually,

the government is trying to solve the problem under the market operation, so

this inefficient and insolvent chaebol can be sold. Chaebols may not be the only

one to be blamed, even though they were blamed as a major cause of Asian

financial crisis happened in Korea brining the country to the brink of

insolvency, as well as weak banking system, in fact, they could be victims of

misleading government policy. The long term close relationship between

government and big business creating rent and using them with unbalanced support

between industries had worked well in the early stage of development, but as

stated early, rent can bring corruption of bureaucracy or industries also, since

it is caused by inefficiency. Allocation of financial resources is not an easy

job, but this would be best time for Korea to consider again about the

efficiency of closed relationship between the government and businesses while

the country is restructuring its economy system.

Blinder, Alan S.. The Economics of Finance. Washington D.C.: the Brooking

institution, 1974. Haggard, Stephan, et al. The politics of Finance in

Developing Countries. London: Cornell Univ. P, 1993. Lau, Lawrence J.. Models of

Development. San Francisco: ICS Press, 1986.