Korea was one of the poorest countries in world after experiencing two wars.
World War II and Korean war (1950 ~ 1953). The country even experienced a food
shortage so that it had to heavily rely on the foreign aid. Yearly per capita
consumption was a mere $88 as late as 1965. However, since 1965, Korea has been
transformed from its underdeveloped agricultural economy to a leading Newly
Industrializing Country. Between 1965 and 1981, its gross national product GNP
multiplied twenty times from $3 billion to $63 billion and per capita GNP
increased sixteen times from $88 to $1,554. There have been many explanations
for Korea’s successful story. Among those, the strong role of government would
be probably the most important one. At the same time, this would be also
responsible for current recession. After Koran war, the government in fact had
no sense of direction and also due to the unstable political situation, the
country didn’t have specific economic policy until 1961 when military
government came to power and established the major institution guiding its
economic planning called Economic Planing Board (EPB). This government set
economic development as the top national priority and recognized the financial
system in support of economic development plan. To achieve this purpose, it
focused its policies mainly on export expansion moving its emphasis from import
substitution. The result was considered quite successful for economic growth.
Between 1965 and 1973, exports grew at average annual rate of 45%, from $175
million to $3,271 million. The success of the expansion was due primary to three
factors (Kwack, 72). The first was a favorable international economic
environment, which saw total world imports expand from $175 billion in 1965 to
$536 billion by 1973. This boom in imports of the world reflected the fact that
the industrialized had not yet erected import barriers against exports from
developing countries and were, on the contrary, quite active importers of
cheaper goods from Newly Industrializing Countries such as Korea. A second
significant factor was the Korean government’s policy of promoting exports,
which was set in motion in 1965. Initially, the government introduced a number
of fiscal and financial incentives, which I will discuss more later. A third
factor was Korea’s abundant and highly productive labor force. This gave Korea
a strong comparative advantage in producing labor intensive products and
provided the impetus for the notable expansion for exports. In order to expand
total exports over time periods, however, Korea turned to new export industries
that were expected to have a comparative advantage with abundant labor, but
skilled labor at this time, such as shipbuilding, electronics, and steel
industries. This attempt was viewed as a manufacturing shifting of its emphasis
from light industries to heavy industries which later started to produce
intermediary goods as substitutes for imports (Kwack, 77). However, this
government’s promotion of heavy industries for large-scale economies led to
under-investment in light manufacturing industries causing productive gap
between small and large firms. Actually, the large firm that runs heavy
industries has been given priorities, and small and medium firms relatively
disregarded in government’s allocation of loanable funds and other
administrative preference. As a result, conglomerates later known as chaebol
(family owned conglomerate) have been formed through this expansion of heavy
industries. Government’s Policy Before 1961 As seen above, the Korean
government has been focused on import substitution for economic growth during
1953 ~ 65 period and followed by export expansion policy after 1965. However, to
progress its policy efficiently, the government had to face to one of serious
problem, poverty. After two major wars, the country even with a food shortage
experienced lack of capital. There was no source for savings and investment to
finance economic growth domestically, so it depended heavily on foreign capital
which inflow in a form of mostly aid and loan in the early stage of economic
growth. The proportion of foreign capital to total capital formation in 1965 was
approximately 40 percent. In addition to inflow of foreign capital, the
government faced allocation of capital with using its financial system. Before
the military government in 1961, the loan decisions of commercial banks were
heavily influenced by political interference (Haggard, 26). Well, in fact the
loan decisions in Korea mostly were affected by political interference rather
than bank themselves until recent time, but during the 1948 ~ 1961 period, the
rent generated by low interest rate was used for its political activities rather
than economic growth. Government’s Export Promotion Policies In the economic
development, the government’s creation of economic rent for certain segments
of business takes critical role. It can be either a source of political and
bureaucratic corruption, but if wisely used, it can be a useful or powerful
policy instrument in supporting business operation and government policies.
Furthermore, it can increase capital formation in the country if it effects a
redistribution of income from consumption to investment activities (Haggard,
23). Since the mid 1960s, the military government used regulated finance as one
of tool to create rent and achieve exports expansion. What it did were
nationalizing commercial banks and amending the Bank of Korea so that it can
control financial systems directly. In general, the Bank of Korea, in its role
as the country’s central bank, determines the allocation of loans, interest
rate level and the supply of money but the decision making in these area is
controlled by the Minister of Finance. In other words, it was government’s
responsibility generating monetary and fiscal policy, not by the central bank.
Since foreign aid started to decline later 1960s, the government reformed
interest rate. It raised the interest rate on (one-year) time deposits from 15%
per year to 30% per year and general loan rate from 16% to 26%. The reform
successfully attracted private saving. In the first three months after reform,
saving deposits increased by 50%. More importantly, this meant more rent, in
other words, more capital to be distributed under government influence. In
addition, the financial reform contributed to a massive inflow of foreign loans
due to the existence of gap between domestic and international interest rate and
since the Korea Development Bank guaranteed to pay back to foreign lender, the
inflow of the loans were accelerated. Also this gap of interest rate was used to
promote export expansion which was the most economic priority. For example,
while domestic interest rate was so high comparing with international rates, the
exporters, mostly big business in heavy industry, were able to get loan at
little interest rate. They were not only able to get low interest rates, but
variety of supports that the government could do such as tax break and easy
approval of the loans for exporters. For example, profits earned on exports have
been exempt from corporate or individual income tax and the short-term export
credit system gave borrowers holding export letters of credit (L/C) “automatic
approval”. As a result, an increase in domestic savings and huge inflow of
foreign borrowings had positive effect on economic growth in Korea due to an
increase in capital accumulation. Controlling exchange rate is another good
example to describe the effect of government’s role on Korean economic
development. After switching its economic policy from import substitution to
export expansion in the mid-1960s, the Korean government officially moved from a
fixed parity to a unitary floating exchange rate system. Although the exchange
rate system has been “floating”, its actual (real) rate was managed by
government’s market control and Korean currency “won” was undervalued
mostly against the U.S. dollar so that the price of exports remain cheap.
Followings are the plans that the Korean government set over time period as a
guide for economic growth. They are quite helpful to understand how major
government’s policies on financial sector have been varied with given the
world economic situations like oil crisis and its own economic recession. The
First Five Year plan (1962 – 1966) The first plan was prepared in a hurry by
the military government that took power in 1961. The major contents of fiscal
and financial policies as stated in the plan document were largely about the
tax, budget, and monetary system, financial market and foreign exchange system.
During this period, its main purpose was, however, to expand exports as much as
possible by providing export firm with cheap loans, tax benefits, export
compensation schemes, and various administrative support. Economic growth in
this period was result by an increase in export and output and as well as price
level (since output and price level are positively correlated), so there was
inflationary pressure at the end of the first plan- actually the inflation rate
exceeded 23 percent in 1964. The Second Five-Year Plan (1967 –1971) During
this period, the major reforms include a financial reform assuring positive
interest rate in 1965, and exchange rate reform normalizing highly overvalued
exchange rate, and trade reform allowing wide imports of parts and machinery
used for the production of export goods. These reforms were reflected in the
second plan and carried further throughout the second plan period. In addition,
there was an increase in domestic savings and a decrease in foreign borrowing.
The Third Five-Year Plan ( 1972 –1976) The third five-year plan put its major
emphasis on the promotion of heavy and chemical industries. The government made
great effort to raise domestic savings to finance the heavy and chemical
industries, but the amount of domestic savings fell far short of investment
requirement. As a result, foreign borrowing expanded enormously, and management
of foreign borrowing and debt became a major policy issue. In addition, due to
different emphasis on light and heavy industries, the growth gap increased
substantially. Inflation caused by the first oil shock in 1973 also takes a part
of unstable situation of economy. Inflation rate exceeded 40 percent in 1974.
The Fourth Five-Year Plan (1977 – 1981) Because of high inflation cause by the
first oil crisis, stability was given relatively high policy priority. The
government adopted monetary rule of fixing money supply growth at a prescribed
constant rate of 20 percent per annual to stabilize price level and overall
economy. He major change in trade policy during the fourth plan period included
the expansion of imports related to exports, maintenance of effective exchange
rate, expansion of export subsidies, tax benefits and foreign loans to export
firms. In addition, the government improved the number of industrial estates for
export firms by creating industrial export estates and free export zones. The
fifth Five – Year Plan (1982- 1986) In the early 1980s, the Korean economy was
characterized by very slow growth rapidly expanding foreign debt, and high
inflation. Consequently, export promotion was given the highest policy priority
again, so the major change in trade policy included intensive promotion of
export goods and market diversification, reform of the export support system,
lowing tariff rates to expand importation of good used in manufacturing. The
Sixth Five year Plan (1987 – 1991) As of 1986 the Korean economy realized high
economic growth, stable price, and a trade surplus and thus faced a new phase of
growth with enhancing the efficiency and strengthen the international
competitiveness of the Korean economy in general by reforming the free
enterprise market system. Thus the major contents of policy reforms included the
dramatic reduction of various government regulations constraining growth of
enterprises plus extensive promotion of liberalization of finance, imports and
foreign exchange. The Seventh Five – Year Plan (1992 – 1996) This plan was
formulated after Korea became a member of the United Nations and emphasized the
role of private sector in preparation and implementation of the plan. The Eighth
Five – Year Plan (1993-1997) The preparation of this plan started with the
beginning of the Seventh Republic and the plan emphasized that management of the
economy will no longer be government led or government controlled, as in the
past, but will be based on the participation and innovative spirit of the Korean
people. It also stresses the importance of reform of finance, government
administration, budgets, ethics, etc. Even though the government on each period
recognized the problems it was facing and made five-year plans, they were not
always successful. Throughout the plans above, we will be able to find a common
policy used without difficulty. That is the government’s massive supports
toward export firms. It must work during the early stage of development when the
country had little capital accumulation. However, the government’s unbalanced
incentives on big businesses which are mostly in heavy and chemical industries,
later known as chaebol, actually led them to depend too long on protection and
debt financing. This policy wasn’t a serious problem when the economy boomed,
but when it slowed, most debt ridden firms fell back on the government for
relief causing the issue whether the policy and the industry are efficient or
not. (Haggrd, 24). For example, the combined sale of the five largest big
companies, chaebol, take 37percent of Korea’s gross out, and their exports
were 44 percent of total exports in 1997. If there is a little slow down of the
one of the largest business, then it is obvious the economy is not in quite safe
situation. Since chaebol’s share of Korean economy is already huge, if they
are allowed to fail or banks are to write off their debt, then the whole banking
system would be pushed into collapse. This is real problem, nor chaebol or their
associated companies, be easily shut down (Economist). As a example, the price
of a 16 MB dynamic random access memory (DRAM) chip fell from more than US $40
in January 1996 to less than US $10 by the end of 1997. The dollar export price
index for Korea’s electronic components fell by 50 percent over the same time
period. Another example is current collapse of Daewoo, a second largest chaebol,
which had huge debt to equity ratio (over 400 percent), went to a bankruptcy
this year. This company was well known with a very close relationship with the
governments in the past. It was ironic to see that Daewoo was expanding its size
when the country was in recession and other chaebols tried to reduce their size
and increase efficiency. Actually, this is not the first time Daewoo asked for
the government’s help. Every time the company went into a trouble, the
government didn’t let the company to fail and put more capital available into
the company. However, this time it doesn’t seem happening that way. Actually,
the government is trying to solve the problem under the market operation, so
this inefficient and insolvent chaebol can be sold. Chaebols may not be the only
one to be blamed, even though they were blamed as a major cause of Asian
financial crisis happened in Korea brining the country to the brink of
insolvency, as well as weak banking system, in fact, they could be victims of
misleading government policy. The long term close relationship between
government and big business creating rent and using them with unbalanced support
between industries had worked well in the early stage of development, but as
stated early, rent can bring corruption of bureaucracy or industries also, since
it is caused by inefficiency. Allocation of financial resources is not an easy
job, but this would be best time for Korea to consider again about the
efficiency of closed relationship between the government and businesses while
the country is restructuring its economy system.

Bibliography
Blinder, Alan S.. The Economics of Finance. Washington D.C.: the Brooking
institution, 1974. Haggard, Stephan, et al. The politics of Finance in
Developing Countries. London: Cornell Univ. P, 1993. Lau, Lawrence J.. Models of
Development. San Francisco: ICS Press, 1986.