Originally published in THE WALL STREET JOURNAL

Tuesday, June 2, 1998

All Is Not Lost for the Won

By MARTIN FELDSTEIN

Board of Contributors

South Korea faces a perilous situation: The high interest rate needed to defend the external value of the won is killing many companies which would have flourished at the interest rates prevailing a year ago. Koreas economy is collapsing--and will only fall further unless there is a rapid change in the countrys economic policy.

In contrast to Thailand and Indonesia, the currency crisis in Korea was not caused by a chronic and growing current-account deficit. Although Korea had a temporary jump in its trade deficit in 1996, when the world price of semiconductors collapsed, by the summer of 1997 it already had a trade surplus.

Korea got into trouble because some Korean investment banks had unwisely used short-term, dollar-denominated borrowing to finance investments in long-term, risky assets. As a result of this borrowing, Koreas short-term dollar obligations came to exceed its foreign exchange reserves. Although that might not have triggered a currency crisis under normal conditions, the events elsewhere in Asia last summer made international portfolio investors particularly nervous. Korea lost reserves rapidly because those foreign creditors feared that the excess of short-term dollar liabilities meant they would not be paid on time. The Korean won fell sharply, from 950 won per dollar in October 1997 to 1,900 won per dollar in December before bouncing back to its current level of 1,400 won per dollar.

Trade Surplus

As part of its program with Korea, the International Monetary Fund now requires Seoul to keep interest rates high enough to prevent a further decline of the won. The IMF fears that a fall of the won could precipitate further destabilizing devaluations elsewhere in Asia, including a possible decline in the Chinese yuan. But unlike Thailand and Indonesia--where a high interest rate is needed to correct the chronic trade imbalance by shrinking domestic demand--Korea had a trade surplus even before it raised interest rates and now has a very large current-account surplus.

The high interest rates in Korea are causing a painful, unnecessary collapse of domestic economic activity. Koreas gross domestic product fell 4% between the first quarters of 1997 and 1998, a dramatic contrast to the 8% real growth rates typical of previous years. Businesses are going bankrupt at a rate of 3,000 per month. The unemployment rate has tripled, creating the threat of civil disorder. Investment in business equipment is down more than 40%. The stock market is at an 11-year low.

None of this is surprising in light of the dramatic rise in interest costs. The interest rate on business loans paid by the best borrowers is now 18%, up from 12% before the crisis began. After taking inflation and taxes into account, the real net-of-tax cost of funds for many of those borrowers has jumped to about 14%, from about 4% before the crisis.

Such high interest rates are particularly damaging in Korea because Korean firms have an unusually high ratio of debt to equity, with typically four times as much debt as equity (in U.S. firms debt is typically only two-thirds the amount of equity). As a result, companies that could comfortably afford the precrisis real net-of-tax interest rate of 4% are heading toward bankruptcy at todays 14% real cost of funds.

The situation is even worse for the small- and medium-size enterprises that provide the bulk of the jobs in Korea. Those firms now face interest rates of 30% and higher, making it likely that many will fail. As a result, banks are generally unwilling to lend to them. The appearance of a "credit crunch" in Korea is as much a reflection of this unwillingness to make loans that are sure to default as it is of the banks lack of capital to support additional lending.

The collapse of corporate earnings and the jump in interest rates also translate into a serious crisis for Koreas domestic banks. By rolling over some of the Korean corporate debt at high interest rates, the banks are just adding more bad loans to their books. Although a full audit of Koreas banks remains to be done, Western analysts estimate that it will take an infusion of new capital equal to about 30% of GDP to protect the existing Korean depositors and to bring the banks reserves into conformity with international standards. The Korean government recently announced plans to provide funds equal to more than 10% of GDP for this purpose. Although even more will be needed, it is clear that Korean officials understand that this is a major problem and are prepared to increase the national debt to help solve it.

The government can also use these funds to end the crushing effect of artificially high interest rates on Koreas corporate borrowers while still keeping interest rates high enough to defend the won. More specifically, I believe that the Korean government should require the commercial banks to limit the interest rates charged on existing business loans to the rates that firms paid in the spring of 1997. (To avoid encouraging firms to increase their debt-equity ratios, this interest-rate cap should apply only to existing loans and not to net new borrowing.) The government would then compensate the banks for capping interest rates by expanding the restructuring fund. The difference between todays market rate and the rate that prevailed last year is 6% but will shrink as increasing confidence in the won allows the overall level of interest rates to drop.

This interest-rate offset would add to the government deficit. But it would be a cheaper way for the government to prevent corporate bankruptcies than allowing them to happen and become part of the banks bad debts, which the government would eventually absorb anyway. Even more significant are the economic and budgetary gains that would result from keeping the enterprises alive instead of losing their productive capacity and adding to the flood of unemployed workers .

Relax the Limits

Lowering the firms interest costs in this way is critical but not enough. The tight limits on the fiscal deficit imposed by the IMF must also be relaxed. Trying to limit the deficit in a sinking economy is a recipe for further economic decline. Until lower interest costs and increased export earnings provide a sufficient turnaround of domestic demand, a tax-based stimulus to domestic spending is needed to bring Korea out of its current tailspin.

Removing the burden of artificially high interest costs and providing a stimulus to domestic demand needs to be tackled if Korea is to avoid the economic and political chaos that would follow the collapse of its corporate sector.

Mr. Feldstein, a former chairman of the President's Council of Economic Advisers, is a professor of economics at Harvard University.