Korea's Fading Economic Miracle 1990-97

By the late 1980s Korea's interventionist and export-oriented development model had contributed to a number of serious structural weaknesses in the economy. Ongoing government involvement in the banking and corporate sectors, weak prudential supervision of financial institutions, and restricted financial market and corporate competition created moral hazard, as banks and corporates believed they would not be held accountable for their actions due to their close relationship with government. This resulted in financial sector risk mismanagement and highly leveraged growth of the chaebols. After 1988, when the new democratically elected civilian administration removed long-standing restrictions on union activity, rapid wage growth, in excess of productivity gains, eroded profitability. These structural weaknesses, and policy errors and mismanagement, made Korea increasingly vulnerable to external shocks during the 1990s. In mid 1995, a rapid depreciation of the Japanese yen and a world semi-conductor glut and price fall provided the trigger for a rapid slowdown in exports and industrial output, and an unprecedented wave of chaebol bankruptcies that undermined the solvency of financial institutions. Korea's long period of sustained economic growth, low inflation, strong investment and balanced budgets had lulled policy makers into complacency. They failed to act decisively to tackle the growing structural weaknesses. Korea's high exposure to short term foreign debt and loss of foreign exchange reserves through a vain and unsustainable attempt to defend the won further undermined foreign investor and creditor confidence. This paper discusses in some detail these developments and their contribution to the financial and economic crisis experienced by the country during 1997-98. It also identifies key lessons for countries contemplating similar rapid development, and key warning signs that need to be heeded to avoid similar happenings to that which occurred in Korea.