Lessons learned from the Korean crisis

Ten Lessons Learned from the Korean Crisis

The Korea Currency Crisis, February 1, 2000

NBER Project on Exchange Rate Crises in Emerging Markets

Jeffrey A. Frankel, Harpel Professor, Harvard University

The excessive optimism of pre-crisis Asia in 1998 gave way to what has now turned out to have been excessive pessimism. Economies are looking better throughout developing Asia, but the recovery has been particularly V-shaped in Korea. The country in 1999 completed two years of recession, re-attaining its pre-crisis level of production. This is just the length of time it took Mexico after December 1994. Indeed, the timing and pattern of recovery has been remarkably similar to Mexico's, as my charts show.

  • First, the trade balance turns from deficit to surplus, amazingly quickly - 1-3 months into the crisis. (1) Unfortunately, the source of the increased trade balance is a fall in income and imports rather than an increase in exports. Nevertheless, reserves start to rise again.

  • The collapse of confidence in financial markets begins to reverse: interest rates and the exchange rate begin to ease 3-4 months into the crisis.

  • The real economy is down for longer, but the steep rise in unemployment levels off at the eighth month, industrial production begins to rise again in the fourth quarter. [Korean unemployment fell to 4.8 % in September 1999.] GDP reaches its pre-crisis level at the end of the second year. After a decline in GDP of 5.8% in 1998, the growth rate was about 9% for 1999.

What are the lessons? I have ten. Some are old conventional wisdom, some are new conventional wisdom and some, I hope, are unconventional wisdom

1. Lawson's Fallacy is still a Fallacy. That is the claim that if a country has a strong fiscal position, so capital inflows are financing the private sector, then a big CA deficit is not a cause for concern. This belief came to grief in Chile in 1982, UK in 1992, Mexico in 1994, and now East Asia in 1997. Worse yet, the post-Mexico modification, also came to grief: namely, that if a country has not only strong public saving but also strong National Saving, so that the capital inflows are going to finance private investment rather than consumption (as in Mexico), then a big current account deficit is not a cause for concern.

2. The composition of capital inflows matters. Statistical studies of early-warning indicators showed that the composition can make more difference than the total magnitude of capital inflows. Short-term, dollar-denominated, banking flows are especially risky, and FDI especially safe. Korea made a mistake by tilting in the wrong direction.

3. Foreign exchange reserves are important. Examples include Taiwan and China, who had high reserves and successfully weathered the East Asia crisis, vs.

Thailand and Korea, where reserves had dwindled to about $4 billion by late 1997.

4. Modern international financial markets are not perfectly efficient, though we are better off with them than without them. The magnitude of the recession in Korea and other emerging markets seems disproportionate to the policy sins committed. (This is not a verdict, however, on the advantages of open financial markets, let alone open goods markets. In the first place, openness may be one of the sources of high long-run growth in East Asia over the preceding three decades. In the second place, the countries may now be emerging from the crisis with reforms that will promote even further promote growth, compared to countries that have never adopted open policies to begin with.) Contagion also suggests imperfect efficiency. The August 1998 spillover from Russia to Brazil and other markets suggests that pure financial contagion, unrelated to real economic fundamentals within the countries, is possible.

5. Moral hazard at the international level (IMF bailouts) can't be the primary market failure, because that would imply too much private-sector money going to developing countries, whereas calculations based on the equalization of K/L ratios and rates of return say not enough money is going in the aggregate). Moral hazard at the domestic level instead was a primary problem in the East Asian case. Bank loans based on personal connections or government guidance rather than investments prospects for high returns, implicit government guarantees, empire-building, etc. I give equal weight to the flaws in the economic fundamentals, on the one hand, and to excessive swings in speculators' enthusiasm, on the other hand. I see no need to choose between blaming the countries and blaming the speculators.

6. IMF programs should sometimes involve structural conditionality in addition to macroeconomic conditionality. Any perceived or actual tendency to impose irrelevant conditions (e.g., US congressional trade priorities) as part of the Korea program is regrettable. Nonetheless, I view the IMF's evolution and expansion of scope -- so as to cover not just macroeconomics but also the structure of the financial system -- as appropriate "changing with the times" and not "bureaucratic mission-creep."

7. Involving the private sector in rescue packages is tricky (arm-twisted investors will pull their money out elsewhere), but it needs to be attempted. It is instructive to compare the unsuccessful December 4, 1997, IMF program in Korea, with the successful second try at the end of the month.

8. Keynesianism is alive and well in Asia. Fiscal expansion is expansionary in the short run, and fiscal contraction is contractionary.

9. When a crisis hits an emerging market, there may be no combination of higher interest rates and/or lower currency that will satisfy international investors, and thereby meet the external financing constraint, without a recession. This is contrary to the textbook theory of targets and instruments. Perhaps the lines for internal balance and external balance don't intersect.

10. As of 1998, we thought we had learned that the one thing you can do to minimize the pain when inflows reverse is to try to devalue early enough -- or else raise interest rates early enough - anything to adjust, rather than try to finance an ongoing deficit. We thought we had learned that Mexico, Thailand and Korea made the mistake of waiting too long, until reserves ran low, so that by then there was no good way out. One variety of this hypothesis is the newly-popular corners hypothesis: you should either adopt a rigid institutional fixed-rate commitment (Hong Kong and Argentina) or, if not prepared to do that, abandon the peg early. (2) On this basis, when Brazil in the Fall of 1998 delayed the seeming inevitable jettisoning of the real target, many thought this would be a repeat of the earlier mistakes, but in worse form because of the delay. Instead, when the devaluation finally came in January, Brazil's trade balance improved sharply and the output and employment did far better than neighboring Argentina.

1. The Korean current account swung from a deficit of 23b in 1996 to a surplus of $11 per quarter in the first half of 1998 (>12% of GDP), or $41 billion in all 1998.

2. Even then we had a counter-example: Indonesia had widened the band right away in 1997, and yet that didn't save it. But one could argue that political instability would have done Indonesia in no matter what. Taiwan, for example, devalued promptly, and suffered far less than the others.