The Principles of Korea's Economic Reform

The Principles of Korea's Economic Reform

"The Asia Crisis: Economic and Political Implications"
New York
April 15, 1998

Ladies and gentlemen, and distinguished guests! I am greatly honored to speak to you about Korea's economic reform. In the resolution of any financial crisis, including the current crisis in Korea, we need the concerted effort of the international community. Your presence here signals a growing awareness of it. Indeed, without support from the U.S. and the international community, Korea would not have been able to achieve the visible progress towards economic recovery that you have witnessed since last December.

After four decades of economic dynamism, sustained growth and expanding trade, the Korean economy experienced a severe setback late last year. But, rising to the occasion, Koreans have demonstrated strong unity and determination to overcome this difficulty. Under the leadership of the reform-minded President Kim Dae-jung, Korea has made remarkable progress in addressing fundamental causes of this crisis. Let me try to explain the principles of Korea's economic reform and the accomplishments since the presidential election on 18 December last year.

President Kim, in his inaugural speech, stressed the complementary nature of democracy and free-market economy. They are like two wheels of a cart: growth of one at the expense of the other causes social imbalance and, ultimately, collapse of the socioeconomic system. From this perspective, I believe the root cause of Korea's economic crisis is its failure to apply the basic principles of democratic governance--accountability, fair competition and social responsibility.

1. Accountability

One of the fundamental principles of democratic governance is accountability. In the public sector, the administrators of the national, provincial, and local affairs are chosen by, and held accountable to, the people--the sovereign--through periodic elections. If the people are denied their right to freely choose public administrators, or if they fail to exercise this right properly, there will be deteriorating public services. In the private sector, similarly, corporate managers are supposed to be held accountable to shareholders--the corporate sovereign.

Until last year, however, this principle of accountability has been thoroughly disregarded in Korea. For too long, the government has ruled over the people with arbitrariness and an authoritarian attitude. It intervened in the market, creating distortions and imbalances that ultimately led to the present crisis. Yet, the Korean people failed to understand the importance of holding the government accountable for its mismanagement of public affairs. Only when the nation was facing imminent bankruptcy, did they manage to vote the incumbent party out of power--but only by a narrow margin of less than two percentage points.

In the business and financial sector, the lack of management accountability has been a far more serious problem. Owing favors to corporate leaders, the government gave them strong decision-making power by severely restricting shareholders' rights. Particularly, in the financial sector, the government acted as de facto management. The government imposed the selection of executives and many of the loan decisions.

Lack of management accountability has encouraged Korean businesses to waste precious resources in self-aggrandizing projects. And our financial institutions have accommodated them with little scrutiny. Due to market interventions from a government armed with a myriad of regulations, it was important for Korean businesses to establish cozy, and often-collusive relations with the government. More often than not, the quickest way to make money was to receive special favors from the government. In this game, to be big in size was an important way of getting ahead, because the larger your corporate empire, the more sources of slush fund with which you can buy influence. The inevitable result, evidently, is over-investment and over-diversification.

This sort of "size game" would not have been possible, had it not been fed liberally by loans from financial institutions. Often-, powerful politicians pressured bank executives into providing loans to the chaebol without any regard for commercial interest. Indeed, this system of government-directed finance was the chief instrument that facilitated the size game. As a result, we have ended up with an industry ailing from too many loss-making projects, a financial system burdened with too many non-performing loans, and a government incapacitated by corrupt officials.

The era of irresponsible management, however, is over. Our new government is absolutely committed to restoring the principle of accountability. To improve transparency and ensure accountability in corporate governance and management of financial institutions, we are requiring the 30 largest chaebol to prepare consolidated financial statements starting from 1999, covering all affiliated companies. Additionally, we have made it obligatory that listed companies appoint outside directors to the board. We have also enacted a new law enabling class action suits by minority shareholders representing 0.05 percent of outstanding shares. President Kim wants to further strengthen shareholders' rights and has recently called for a revision of this law to allow class-action suits by minority shareholders representing 0.01 percent of outstanding shares. When shareholders begin to demand a reasonable rate of return on their investment and replace management that fails to deliver, corporate leaders will no longer attempt to expand their empires recklessly through over-investment and over-diversification.

Another source of pressure on the management is the possibility of a hostile takeover. In the past, hostile takeovers were not allowed in Korea. It seemed good to oppose anything "hostile." However, as a result of our determined effort to educate the Korean people, they are beginning to understand that the only desirable way for management to defend itself is to manage well. We have abolished the provision for mandatory tender offers and legalized hostile takeovers. Nevertheless, advocates of vested interests managed to insert a clause requiring an approval by the board of directors when anyone wishes to acquire more than one-third of outstanding shares. This effectively excludes the possibility of hostile takeovers. It is unlikely that any board will approve an unwanted takeover by a third party. President Kim recently called for the repeal of this clause.

To restore the health in the financial sector, we have also put an end to the practice of government-directed finance, and strengthened supervision of the financial industry to ensure its accountability and transparency. In addition, we are vigorously promoting deregulation and free competition. With market discipline established in the financial industry, over-leveraged firms must retrench and restructure quickly; or else they will not survive. There will no longer be special favors to selected firms or industries from the government. The market will be the only and final judge of all business decisions. The market will drive the restructuring of Korean industry.

2. Fair Competition

Since the days of Adam Smith, economists have widely recognized the beneficial effects of unimpeded competition. The market system yields efficient outcomes only if free and fair competition is guaranteed. Moreover, competitiveness can be enhanced only through an exposure to tough marketplace competition. This is how Korea achieved its economic miracle. Through aggressive promotion of exports, Korea forced its exporters to learn how to compete with foreign rivals in global markets.

Regrettably, however, free and fair competition was not allowed in the domestic market. The government has for too long protected big businesses with various entry and exit barriers, barriers against foreign capital and foreign goods and services, and other regulations that restrict competition. In addition, due to the lack of legitimacy, the authoritarian governments in the past tried to appease organized labor by making layoffs nearly impossible. Not surprisingly, Korean firms have lost competitive edge.

Free and fair competition is not possible in an economy in which the rules of the economic game are not transparent. Transparency in the private sector, as well as in the government, therefore, will be a central goal in the reform drive of the new administration. Furthermore, we will get rid of all impediments to free competition and establish transparent rules. Our Fair Trade Commission will no longer be an apologist for the chaebol. Instead, it will act as a tough enforcer of fair competition rules.

Openness is going to be another key element in the reform drive. We do not embrace free trade simply because it is required by the WTO. Nor do we accept it because we fear pressure from some powerful nations. We embrace free trade because we believe in the virtue of free competition with the outside world. There will be no more discrimination against foreign products, companies and capital. We will no longer encourage austerity campaigns to discourage consumption of imported goods. And we will welcome foreign investors with open arms.

Koreans have traditionally been suspicious of foreign investors. Until recently, few Koreans wanted to allow foreigners to own small shops or restaurants, and even fewer favored allowing foreigners to buy land in Korea. However, during his nationally televised town meeting on 18 January, then president-elect Kim Dae-jung stressed the importance of foreign capital in the rebuilding process of our crippled economy. He courageously took an unpopular position and tried to educate the nation. I am happy to report to you a poll taken on the day after the town meeting, and a follow-up poll taken the next month, showed 73 percent of Koreans now think foreign capital is beneficial to the national economy.

During the last three months, we have enacted many policy changes to open up our capital market. In the stock market, we have raised the foreigners' total investment ceiling from 20 percent to 55 percent of outstanding shares. And this ceiling will be abolished by the end of this year, although the 50 percent ceiling for individual investors will remain for the time being. (The investment ceiling for quasi-state companies was raised from 21 percent to 25 percent, and the individual ceiling from one percent to three percent.) In addition, we have eliminated all restrictions on foreigners' investment in the bond market. Foreign investors can now invest without limit in all listed bonds issued by the government, government agencies and corporations. Foreign investors are also allowed to invest in money market instruments such as commercial paper, and commercial and trade bills issued by corporations. But, in order to reduce the impact that might be caused by a sudden in- and out-flow of speculative money, short-term financial products issued by financial institutions, such as CDs, RPs, notes and cover bills, will be opened to foreigners at the end of 1998.

3. Social Responsibility

A democratic society must care for those who are unable to care for themselves because they can not keep pace with competition in the labor market. However, the Korean government in the past tried to shift this responsibility to employers by making it nearly to lay off employees. We made the private sector fulfil the responsibility to provide a safety net for workers. This kind of "private" safety net system works well as long as the economy enjoys sustained growth, since there is no need for a safety net when the economy is growing. However, under this arrangement, the safety net is not there precisely when it is needed. In a period of severe recession, many employers find themselves unable to guarantee job security.

We need to replace our system of private safety nets with that of a social safety net. To do so, we must first restore labor market flexibility and do away with the system of lifetime employment. When a company is in danger of bankruptcy, due to high labor costs, a company should be allowed to lay off some of its workforce and let society take care of the unemployed. By trying to keep the entire workforce employed, regardless of a company's financial health, we may sometimes drive a company into bankruptcy and thereby jeopardize all of the employees' jobs. Under such circumstances, the society would find itself overwhelmed by a large unemployed population.

In a landmark agreement engineered by President Kim, representatives of labor unions agreed to accept layoffs in exchange for a social safety net. Given the strong national consensus arising from the crisis atmosphere, President Kim could have acted unilaterally to impose labor market flexibility. But, wisely, he chose to persuade labor into a voluntary agreement. His patience paid off. After many breakdowns, a Tripartite Committee, consisting of representatives from labor, management, and government reached an agreement, paving the way for the National Assembly to amend the labor relations law to allow layoffs.

In my view, one of the most significant legacies of the current economic reform will be that Korea installed a decent social safety net for the first time in its long history. There is an old saying in Korea that "Even the state cannot relieve poverty." But, in a modem democracy, poverty relief is the responsibility of the state. Now is the time for the Korean government to take this responsibility seriously.

And we are taking it seriously. We are planning to spend over 10 percent of the central government budget for social safety net programs, consisting of unemployment insurance, income supplement, job retraining and a job information clearing house. On the other hand, we are well aware of the danger from overgenerous social programs. We have the benefit of drawing from the experiences of advanced economies.

4. Concluding Remarks

Korea has come a long way since it narrowly averted defaulting on its external liabilities. Even before his inauguration as President, Kim Dae-jung took command of the nation's economic affairs and adopted many reform measures. Only five days after the election, he persuaded then incumbent President Kim Young Sam to create a Joint Economic Committee-a de facto transition government on economic policies. And almost immediately, through this Committee, Kim Dae-jung began implementing long-waited reform policies. In a three-month period after the election, President Kim has managed to adopt far more reform measures than his predecessors have.

As a result, the foreign exchange market. is gradually regaining stability. The exchange rate, which stood at one point above 1800 won to US$l, has fallen below 1400 won, thanks to the successful conclusion of the negotiations for maturity extension of our short-term debts and rapidly improving financial status. The current account balance during the first three months of this year ran a surplus over US$10 billion, and the foreign exchange reserves, which barely exceeded US$7 billion at the end of November 1997, will exceed US$30 billion by the end of this week. Reflecting these trends, the IMF, in its latest World Economic Outlook, forecasted Korea's GDP percentage growth at a negative 0. 8 for 1998, but a 4.1-percent gain in 1999.

The tasks are far from finished, however. First and foremost, we must act fast to restructure and revitalize our financial sector. Without a properly functioning financial sector, the real sector can not regain viability. Financial sector reform is also a prerequisite for a successful reform of corporate governance. In addition, we must educate shareholders to be assertive in demanding reasonable rate of return on their investment and holding the management accountable for its performance.

Above all, we must remain steadfast in our commitment to the reform process. No nation can complete reform in one giant step. Often, successful reform in one area brings about a need to reform in another. For example, we could not, and should not, have imposed labor market flexibility without guaranteeing social safety net programs. Once instituted, however, there is a tendency in a democracy to make social services more generous over time. Eventually, social programs could become a burden to the national economy, and there arises a need to reform these programs. Thus, reform is a continuous process.

There are only a handful of nations on this globe that have been reasonably successful in economic reform. An outstanding feature of these countries is the fact that they have maintained a steady course of reform for more than a decade, even when there were changes in government from one party to another. In particular, the United Kingdom and the United States, the sometimes-derided Anglo-Saxon economies, have been on this path for nearly two decades. We would be fooling ourselves if we thought we could rectify most of our problems in a year or two. We are realistic. We are going to stay focused on the principles of reform and continue our effort to implement necessary policies. We are determined to succeed. And you can count on the resiliency of the Korean people.