CASE STUDY: KOREA STOCK EXCHANGE, 1998

Story prior to 1997-98

 Korean economy had grown at 8.6% annually

 By 1996
o 11th largest economy of the world
o Member of OECD

Korean economic system (Export oriented economic strategy):

 Bank centred financial system

o Korea did not rely on the stock market in order to channelise savings to industrial investments. It
relied on its banking system
o It was believed that it facilitated long term investments as a close relationship between industrial
enterprises and financiers was possible (absent in stock market)
o Government had significant influence on the banking industry
 Ownership and appointment of bank directors, they had direct influence bank’s
lending decisions to further its economic development plans
 Chaebol system
o Korea dominated by multi business organizations known as chaebols
 30 largest chaebols – 51.8% of total industrial output (1996)
 Top 4 chaebols – % of total industrial output (1996)
o Government policy favoured growth of chaebols
 Granting industrial licenses
 Distributing foreign borrowings
 Favoured access to bank financing
 Interest rate for borrowing from domestic banks was higher than foreign banks.
Privilege of borrowing from foreign banks fostered chaebol’s growth
o Benefitted entrepreneurs
 Market imperfections, financial market was characterized by
 Lack of adequate disclosure
 Weak corporate governance and control
 This made it costly to establish quality brand image in market and establish
contractual relationship with joint ventures
 Financial intermediaries were absent or not fully involved
 This made it costly for entrepreneurs to acquire necessary inputs
 Securities regulations were weak and enforcement uncertain
 All this made it profitable for entrepreneurs to be associated with Chaebols
o They could use their brand names to invest in world class brands
o Financing
 Relied extensively on domestic and foreign debt; it subsequently arose as financial system
was bank centred
 Government policy restricted FDI, foreign money for chaebols only through banks/ other
financial institutions
o Family ownership- key factor
 Enhanced through equity cross holdings
 Founder or founder’s family-direct control-through small ownership
IMF Crisis

 Began in Thailand
 Foreign financial institutions started calling in their loans
 Foreign reserves were depleted
 IMF provided $55 billion bailout package

Causes of the crisis

 In July 1997, Thailand’s currency devalued as foreign investors lost their confidence in the Thai economy.
Markets fell all over Asia. Impact could be seen in Korea as concerned foreign financial institutions started
calling back their loans rapidly and tightening credit. Foreign reserves were dangerously low by October.
Korean companies found themselves unable to pay back loans as credit was not available. Economy came
close to crashing.

 The Korean currency crisis resulted from a serious mismanagement of foreign exchange rates and foreign
currency reserves as well as the accumulation of short-term foreign debts. Although it is generally believed
that the exchange rate of the won started depreciating drastically on 8 November 1997, depreciation started
three months earlier when the international market conditions put pressure on the won.
 The Korean crisis had its roots in chaebols. Their close connections to politicians and government officials
facilitated them to acquire loans without much resistance from banks. Lack of supervision by banks This easy
access to financing topped with government’s emphasis on job creation made chaebols to focus extensively
on growth and expansion, ignored profitability.

Search for solutions

Banks and chaebols were under attack. Chaebols focussed more on expansion than profitability. Hence, the new
president asked the chaebols for reform else face punishments.

IMF proposed a lot of reforms which invited both supporters and non-supporters. People were worried that there
would be layoffs and social instability.

 Economic restructuring
o Financial supervisory committee (FSC)
 Reform banks first
 Corporates to be restructured through bank reforms
 Bank restructuring
o 12 banks
 5 closed (acquired by healthy banks
 7 bailed out with charges in management, cost control etc.

Conditions for acquiring bad banks by healthy banks

o Only good assets would be sold with a six-month put obligation

o Government would inject fresh capital to enhance acquiring bank’s capital adequacy to pre-
acquisition levels
o Acquiring bank’s bad assets would be purchased by KAMC

Approximate losses of 60 trillion won borne by financial institutions to be raised by Korean Government
o 50 trillion through bonds
 41 trillion: Non performing loans
 9 trillion through equity
o Approximately 20 trillion to be raised through issuing new equity
  Corporate restructuring
o Short term: Close non-viable enterprises and improve the financial condition of the rest
o Long term: Improve management and governance of chaebols
o Based on five principles
 Improve financial structure
 Eliminate practice of mutual guarantees of loans among affiliated firms
 Focus on core business structures
 Increase transparency
 Improving corporate governance
o FSC
 Viable
 Subject to exit
 Subject to restructuring
o June 1998: 55 companies exit (20 were from top 5 chaebols)
o Reduce debt to equity ratio from 500% to 200%
 FSC→ Chaebols:
 Identify core business
 Prohibited cross guarantees

Government gave tax benefits, simple mergers and allowed spin offs and carve outs

 Attracting foreign capital

o FDI important
 To sell assets
 They bring strong management policies
o Government relaxed policies and gave benefits to firms
o Foreigners critical about valuation and layoffs along with the concern of inverting through stocks
o Korean stocks risky
 Poor accounting
 Poor auditing
 No threat of takeover
 Developing capital markets
o 1976: Revision of Securities and exchange law
o No. of listed companies
 66 in 1972
 356 in 1978
 776 in 1997
o Market capitalisation increased from 246 billion won to 71 trillion won (1972- 1997)
o But, market value to GDP declined
 40% in 1994 and 1995 TO 30% in 1996 TO 17% in 1997
 Finance through stocks
 23% in 1989 TO 7.87% in 1997
 Reduced confidence of investors in stocks because of roller coaster performance
post 1988. No long term approaches.

Recent developments

 Made infrastructure changes-opened derivative markets

 Changes in accounting rules: Follow International Accounting Standards
 FSC overtook accounting standard settings
  Changes made for:
o Minority shareholders
o Hostile takeover
o Restrictions of institutional investors’ voting rights abolished
o Foreign investors voice heard
o Plaintiff voice heard

Future challenges

 Making the entire system (banks, government and the business) transparent
 Audit by reputed international accounting firms
 Minority shareholder responsibilities not paid the required attention
 Instability of stock markets: liberalization (of stock markets) proposed as a fundamental solution
 Concerns over lack of institutional infrastructural support