ASIAN AFFAIRS ON KOREA Philippe Delhaise - President - Capital Informations Services Ltd THE REHABILITATION OF THE KOREAN FINANCIAL SYSTEM. The Korean leaders have embarked in an ambitious plan to restructure the country's banking system. It would be difficult to capture the extent of their efforts without first examining what the situation was prior to the Asian crisis of 1997. Politicians have succeeded in deflecting criticism by putting the blame for the crisis on the rest of the world, to the point where the man in the street in Seoul still calls the crisis "the IMF crisis". While there is no denying that the crisis would not have erupted quite in the same way without the contagion effect from Thailand, it is fair to state that the Korean banking system was in poor shape well before 1997. It would have met its cruel fate one way or another. THE KOREAN BANKING SYSTEM PRIOR TO THE ASIA CRISIS For years before the 1997 crisis, most Korean banks were simply incapable of producing enough current profits to provide a cushion against bad loans, let alone to give investors a reasonable return on equity. The banks were instrumental in the financing of Korea's remarkable growth over 25 years but, in the 1990s, they found themselves unable to attract fresh capital funds to sustain the growth of their balance sheet. The Gross Profit Margin ("GPM") is a good indicator of a bank's capacity to generate wealth. It is defined as the ratio of net profit before taxes and bad loan provisions to average total assets. In order to prosper, a bank should exhibit a GPM of at least 1% in good years and considerably more when a weak economy translates in a high level of non-performing loans. The GPM for the major Korean banks (the so-called "nationwide banks") was, on average, 1.09% in 1994, 0.57% in 1995 and 0.48% in 1996. This compares very unfavorably to the average GPM of banks in the Philippines, Thailand, and Malaysia and of private-sector banks of Indonesia which was over 2% in all three years. By far the most obvious reason why Korean banks were so unprofitable is that they were wildly overstaffed. According to some studies, banks should have eliminated two-thirds of their staff to survive. Labor costs are the main component of administrative costs in retail banking. In the first half of the 1990s, Korean banks were spending two-and-a-half times more to run their banks than did comparable institutions in Hong Kong and Singapore. Such a low wealth generating capacity made it impossible for Korean banks to address the need for provisions in the early 1990s, so much so that, by the end of 1996, non-performing loans were in the vicinity of 12.5% of total lending. According to published statistics, the official level was only 4.5% in 1996, but this was based on a very loose definition of non-performing loans. Worse was to come as sorry cases like those of Hanbo Steel (January 1997), Sammi Steel (January 1997), Jinro distillery (April 1997) and Kia Group (July 1997) all hit Korea before the so-called IMF crisis. The Chaebol structure where a small number of large conglomerates control a huge proportion of the economy plunges the banks into a substantial systemic risk as their exposure to any single group sits usually well beyond internationally-accepted norms. For example, Korea First Bank had an exposure to the Hanbo group equivalent to 60% of its own equity and some small banks were found to have over 120% of their own equity at risk in some of the names that failed in 1997. Korean banks were fully aware of those weaknesses and most of them started looking for additional sources of income, sometimes at the behest of the authorities. For example, most of the major banks invested heavily in the stock market as a way of supplementing their profits. While 1994 was a good year for Korean equities, banks lost heavily in 1995 and 1996. In 1995 alone, the major banks lost at that game close to 20% of their own equity, instead of finding much-needed additional profits. Some banks, especially the new merchant banks, took wild bets on Russian or Brazilian risks, or lent dollars to the weakest borrowers in such countries as Indonesia. It is not difficult, therefore, to understand that, while the 1997 crisis acted as a revelator of those weaknesses, the Korean banking system on its own was heading for serious problems. Three years after the crisis, it would be interesting to examine whether Korea has addressed the causes rather than the symptoms of its financial difficulties. THE KOREAN BANKING SYSTEM IN 2000 There is no denying that the legendary dynamism of the Korean people has, to a large degree, restored Korea's financial position. Early in 1998, Korea had to obtain the restructuring of US$ 24 billion of short-term debt. By the end of 1999, Korea again had substantial foreign reserves and they have grown further in 2000. The economy is growing again at rates close but below those seen before 1997. Korea has recorded more foreign direct investment in the past two years than it has in the previous two decades. The published fiscal deficit remains within acceptable limits. The savings rate remains very high, inflation and unemployment are relatively low, and exports still boost the economy. The government has promoted the development of small and medium-sized enterprises. Over 30,000 such companies were created both in 1999 and in 2000. There are some clouds over that success, but Korea might be able to escape them. For example, foreigners have invested substantial amounts of relative volatile funds into the Korean stock market. This represents a huge proportion of available reserves that could disappear quickly. Another example is the natural dependence of Korea's exports on the strength of other major economies. The financial sector is under rehabilitation and the government has taken some spectacular measures. Non-bank financial institutions are in poor shape, but the most prominent measures have affected the banks, which are larger, more visible and more relevant to the country's recovery. Asset Management Companies As a first measure, non-performing assets had to be reduced. Two government agencies (KAMCO and KDIC) have taken over about US$60 billion in bad loans from the banks. Most of those will have little residual value and the taxpayer will have, at one point in the future, to foot a bill that represents a whopping 12% of GDP. Meanwhile, the bad loans left in the books of the banks represent another 15% of GDP, even by relatively lenient official measures. More taxpayer money will be needed. Taking bad loans out of the books of the banks is meant to allow them to face the future with some serenity and, more importantly, to start lending again. Most of the countries that suffered during the Asian crisis went through a period of credit crunch in which banks, burdened with bad loans and short of liquid funds, were reluctant to extend any new line of credit. Conceptually, it is open to question whether those government agencies, usually called after a variation of the euphemistic "Asset Management Company", are better positioned than the banks to liquidate non-performing assets in an orderly way. It seems that KAMCO did a better job of it than did some of its counterparts in Asia. The government has strict rules about what loans qualify for takeover. On another front, both in 1998 and 2000, it established sometimes controversial "kill lists" of non-viable companies that, in many cases, will lose the artificial support of the banks. As in other Asian countries affected by the crisis, many companies are struggling to meet their financial obligations and it can be feared that quite a number of them will not have the cash flow needed to start servicing their debt in any meaningful way. Meanwhile, banks -especially state-run banks- have injected large loan amounts into ailing companies, and they have sometimes swapped debt for equity. While debt-for-equity agreements may occasionally result in better recovery hopes both for the companies and for their banks, such deals also allow the banks to overstate the true value of their assets, as mark-to-market approaches are not favored. This blurs the picture and makes it difficult for regulators and external observers to gauge the banks' soundness. Mergers and Liquidations The second leg of the rehabilitation efforts involved the liquidation or the merger of some banks, while foreigners were invited to bid for some local financial institutions. The number of commercial banks went down from 27 to 17 in three years. Merchant banks are down from 30 to 9 and Investment Trust Companies from 31 to 24. It is highly questionable whether the merger of two weak banks can miraculously result in a stronger merged entity. Korea was, in the matter, better than some East Asian countries since, in many cases, it forced the merger of weak small banks into large stronger banks, rather than the reverse. This still resulted in a weak entity but it had a sporting chance of surviving. In fact, Korea was fortunate to have four or five relatively good banks that survived the crisis, but their future suddenly became affected by strong government pressure to take over weak financial institutions. This "convoy system" is typical of North Asia, but it seldom produces brilliant results. Beyond specialized banks, the government now runs several large commercial banks, following rescue schemes. The merger of several such banks, with the view of creating a major institution, was discussed in June 2000, but has not materialized yet. The government has been less successful with the Chaebol. It requested them, among other things, to reduce their gearing ratios, to rationalize their operations and to eliminate cross-subsidies in favor of ailing divisions. The Chaebol, however, belong to the private sector and can hold the government at ransom because the outright failure of several major Chaebol would have serious repercussions for the entire economy. While a number of improvements did take place, the Chaebol have largely kept their system as it was, thereby undermining efforts at limiting the banks' propensity to lend beyond single borrower limits. In addition, good corporate governance is still a distant goal of little interest to most. Labor Relations A third important aspect was the general attitude towards labor relations. Until 1996, Korea was operating under a very rigid system, not unlike the Japanese model, where it was extremely difficult for companies to lay off workers, even under extreme economic conditions. Trade unions were very vocal and they combined a militant spirit only found in socialist Europe with the kind of stubbornness that has thankfully seen Korea through its most difficult times. After some political wrangle and numerous riots in the streets, the Labor Laws were amended in 1996 and 1997 and are now closer to the Western model. Banks did not lose time to shed some staff: about 40,000 bank employees have so far lost their jobs. Interestingly enough, while bank workers were far from being the only ones to lose their jobs, unemployment at about 4% has remained relatively low in Korea, and it is slowing down. This is partly an indication of the creativity at work in the country and it is a welcome improvement over the old model. Workers have recently started voicing discontent at being the main victims of the restructuring, though, pointing to the fact that little has been done to punish those responsible for the crisis. Little do they know that the restructuring will also inevitably hurt them as taxpayers. Fresh Bank Capital To cap it all, the Korean government has pledged additional funds both for a further takeover of non-performing loans and for the re-capitalization of the banks, which largely amounts to the same thing. The funds earmarked for the injection of capital amount to the equivalent of about US$ 45 billion, or 9% of GDP, while new additional funds meant for non-performing loans will depend on the banks' needs but may reach a similar size. Public funds are injected in selected banks under certain conditions that include approved self-rescue plans. Those plans are focused on reaching, among other targets, better per capita operational profits and lower levels of non-performing loans. THE FUTURE It is too early to decide whether the banking system's rehabilitation will meet with success. No doubt the taxpayer has taken over a huge burden that will affect the nation's accounts for years. Yet the fundamental improvements in the way banks operate, from their operational efficiency to the way loans are written, may remain on the short side. A close scrutiny of the accounts of the banks for the year 2000 will give an indication, but clearly the banking system remains vulnerable. This is particularly true for some of the major banks now back under government control. Such control thankfully carries the protection of additional public funds, should the need arise. It should be feared, however, that isolation from market forces might hinder their efforts at rehabilitation. It is also doubtful that the necessary transition back to the private sector, the key to a wider access to capital funds, would take place in the immediate future, at least until more substantial reshaping takes place. Clearly, the health of the economy in general will have a considerable impact on the success of the financial sector's rehabilitation. Yet the most important factor remains Korea's attitude in respect of the corporate sector. Without significant corporate restructuring, to include a cultural change away from the convoy-system mentality and a serious improvement in corporate governance, the rehabilitation of the financial system might not be accomplished before some fresh crisis hits the country. January 2001
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