Changyong Rhee on Korea and the Asian Financial Crisis

Continuing our series on the Asian financial crisis, we spoke with Changyong Rhee, Director of the Asia Pacific Department at the IMF. Changyong is a well-respected economist who has worked as an academic, an advisor to the Korean government, and at a variety of international institutions. He brings along many years of experience covering economic and financial developments in Asia.

Some of the key takeaways of our conversation with Changyong include:

  • Korean policymakers were aware of the risks of opening up financial markets and pursued a gradual and indirect approach to capital account liberalization.
  • Financial liberalization prioritized indirect borrowing by financial institutions, rather than more stable FDI, making Korea susceptible to capital outflows during the crisis.
  • Although strong cooperation between the government, conglomerates, and banking sector was critical to South Korea’s growth, it also created large moral hazard problems.
  • The IMF program helped Korea restructure its economy and become more resilient to financial shocks, but some of the policy recommendations created domestic backlash.
  • While Asian economies are in a far stronger position compared to the past, there are still significant economic risks stemming from high leverage and rapid demographic aging.


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Nicholas Borst:

Welcome to Pacific Exchanges. A podcast from the Federal Reserve Bank of San Francisco. I’m Nick Borst.

Paul Tierno:

And I’m Paul Tierno. We’re analysts in the country analysis unit here at the San Francisco Fed. It’s our job is to monitor financial sector developments in Asia and as part of the Fed’s public mission, share information and analysis with listeners like you. Today, we continue our series on the Asian financial crisis 20 years later.

Changyong Rhee:

Ex post, yes it is very difficult to argue that the order/sequence of the financial system liberalization were proper, but it’s fair to say even by then, that Korea’s authority and Malaysia, Indonesia government were very cognizant of the risk of financial market liberalization.

Nicholas Borst

In today’s episode, we sat down with Changyong Rhee, director of Asia Pacific Department at the International Monetary Fund. Changyong is a well-respected economist who has worked as an academic, an advisor to the Korean government, and at a variety of international institutions. He brings along many years of experience covering economic and financial developments in Asia.

Paul Tierno:

It was really great to speak with Changyong and get his unique perspective on what drove the Asian financial crisis in South Korea. He did a fantastic job highlighting the difficulty a relatively small economy such as Korea faces in managing international capital flows. He also had some interesting takeaways on how Korea has restructured its financial system, and key medium term risks Korea and the rest of Asia face going forward.

Nicholas Borst:

Yeah, I found it interesting how he challenges the notion that Korean policy makers were not aware of the risks of opening the capital account before the crisis. He also makes a great point about how the IMF’s approach to crisis management changed dramatically following the events in Korea.

Paul Tierno:

I agree. Let’s hear our conversation with Changyong.

Paul Tierno:

Thank you for joining us today.

Paul Tierno:

From your perspective, can you tell us what were some of the causes of the Asian financial crisis in Korea and how did Korea’s experience differ from that of other Asian countries?

Changyong Rhee:

Okay. Regarding the similarities, I think Thailand, Indonesia, and Korea all share the so-called double mismatched problem. Currency mismatch and maturity mismatched. These countries are borrowing short term debt in dollars and then financing longer term lending in domestic currencies. This double mismatch was particularly detrimental as the significant depreciation of the currencies ballooned borrowers debt burden, led foreign lenders to refuse rolling this short term debt, and triggered a massive default of bank and corporations.

Other commonality across these countries was their bank formulated financial market structure, with inadequate regulation and supervision. I suppose it was noticed that domestic banking regulations and supervisions were weak, internal risk management was lax, and the regulators could not prevent excessive risk taking, but those are the kind of similarities.

As for the differences, I think the differences were in granularity. Thailand encouraged capital inflows to be channeled through a mostly domestic banking system, and then also an offshore banking entity named BIDF, which become notorious now. These flows were mostly invested in real estate sector, causing overvaluation of Thai Baht and bubbles in their estate, which eventually collapsed.

In Korea, capital inflows were also channeled through domestic banks, but they were used to finance investment by conglomerate—or chaebols–, particularly in export and manufacturing sector.

Nicholas Borst:

Can you talk a little bit about the role of contagion? The crisis started in Thailand, an emerging market, but then spread to Korea which was a much more developed market.

Changyong Rhee:

Yeah. Actually I think the contagion play a very important role, not just for Korea but also in Malaysia for example, which has relatively maintained a relatively closed capital market. I think given the vulnerabilities they had, such as high leverages, those kind of information was not well known by that time to the investors.

In some sense, moral hazard problem existed for the investors too, because they lend the money based on the past high growth rates in this country, but once Thailand had the problem, then investors start to look at the Asian countries in more detail. Then that caused some concern from the investors on the Asian countries.

At the same time, I think some of the mistake in handling this pre-crisis period by several Asian countries, such as trying to maintain the exchange rate around the time, and then also how to handle the information flows to the investors. Those kinds of things aggravate this contagion process.

Nicholas Borst:

During much of the 1990’s, Korea was in the process of financial liberalization, opening up its markets to foreign investors, but at the same time it hadn’t completely opened up. There were still some controls, as you mentioned, on the exchange rate, controls on long term borrowing. Can you talk about how this role of financial liberalization, how this process of financial liberalization in Korea impacted it with respect to the financial crisis?

Changyong Rhee:

Yeah, actually I think many people say that the sequencing problems or the ordering problem of the financial system liberalization was main cause of the Asian crisis, but I have a slightly different view. Ex post, yes it is very difficult to argue that the order/sequence of the financial system liberalization were proper, but it’s fair to say even by then that Korea’s authority and Malaysia, Indonesia government were very cognizant of the risk of financial market liberalization.

That is why in particular in Korean case, the Korea government favored the gradual and indirect strategy. Rather than opening domestic market to their foreign investors, so they actually didn’t open the domestic market to foreign investors or they didn’t allow the corporation to directly go to foreign market directly. The authorities only allowed domestic financial institutions to borrow from abroad, and then lend the fund domestically to corporations.

They called this the indirect and gradual approach. That policy was aimed at securing local financing from abroad while preventing speculative capital flows, because they believed that speculative capital flows will be mostly done by foreigners. So, they presumed that risk from capital inflows, channels from domestic financial institutions were much easier to oversee. In hindsight, this turned out to be quite wrong. Domestic financial institutions failed to adequately manage the foreign exchange and credit risk, and that resulted in massive banks and corporate default.

Also, I think ex post, we now understand better what was the downside, risk of this indirect approach. Since the domestic financial market was not open to foreign investors at all, the rise in domestic interest rate after the crisis happened, and then as a part of the IMF policy could do very little in deterring a massive outflow of foreign capital, because there are no foreign investors from the beginning. Then as a result the investment burden fell entirely on the FX market, increasing the size of currency in a collapse.

In sum, I would rather say that the authorities were fully aware of the theory, and that the financial opening exposed risk and speculative attack. I think in some sense they also had been naïve to believe that the partial, gradual, and indirect approach could mitigate the risk sufficiently. Maybe one lesson that we learned is that once the market’s integrity passes a certain threshold for a small economy, maybe it’s impossible for them to control the formal speed of the capital market opening entirely. Maybe the prudent macro policy and maintained a sound financial market is really prerequisite to prevent the crisis.

Nicholas Borst:

You mentioned the idea of using financial institutions as an intermediary to try to control some of these risks. One of the interesting things during this period was the proliferation of new types of financial institutions, such as the merchant banks. Do you think supervision was adequate towards these new types of financial institutions, or did that contribute to the overall problem?

Changyong Rhee:

Yeah, actually, at the time, it definitely they are less regulated and more than the bank. Actually, they were one of the major of these institutions who actually channel these funds from abroad to domestic corporations. They believed this as a gradual part of the liberalization process and they really believed that government can control and then oversee the financial institutions better than overseeing the foreign institutions or the corporations. But, ex post, it turned out to be wrong.

Paul Tierno:

That’s a great segue to our next question, the Korean government has historically played a large role in the economy, and we wanted you to talk a little bit about the role of Korea’s government intervention, including directed investment as well as the concept of moral hazard and too big to fail, specifically pertaining to chaebol, played in the Asian financial crisis in Korea.

Changyong Rhee:

Yeah, I think it’s simple to just say that the too big to fail perception was quite strong, and it was the basis of the moral hazard. I think it’s true, but I think we need to look at the why there is the belief. More in Korea, why did people believe too big to fail more, even if the size of the chaebols compared relatively with other sectors may not even outrageously large in Korea than compared with other countries.

I think the main reason why we had a more serious problem with too big to fail, a moral hazard problem is because of our history of how the government has managed the banking sector. In Korea, financing chaebol investment as a part of industrial policy has been a major responsibility of the banking sector. Everyone believed that what is bank’s law is basically to support the government industrial policy to have a higher growth at the time.

As such, bank doesn’t need to have a function to really scrutinize the corporation’s balance sheet or analyze the financial risk of their main investment, because this is part of the bigger picture of the Korea corporation’s investment plan. As such, the banks thought that the government would bail out these investments if they were to get into trouble. This perception led banks to ignore or underestimate the underlying balance sheet weakness, and that is a main cause of why the corporations are very easy to, especially with large ones, it is easy to increase their leverages.

You can call it a moral hazard problem, but this is deeply rooted in the history of the economic development process. That I think we had a good economic growth thanks to this kind of cooperation between the government, retail sector, and banking sector. We also learned that when something goes wrong, and it amplified the cost a lot.

Paul Tierno:

Did the government react toward the chaebol the way market observers expected them to react? If so or if not, how did the differing reaction to various chaebol failures affect the market sense?

Changyong Rhee:

Actually in Korean government used the strategy which made the Korean chaebols compete with each other. We basically Korean government supported the export oriented chaebols, because at the time the export is a very important source of the growth. Then when chaebols become successful in export sector, they continued to support them and through the indirect financing and investment.

When our economy size was smaller and was underdeveloped, the government has much better information than most of chaebols. The government can lead this industrial policy, but I think that from 1980’s, I think the private sector also become much larger. I think it will be a good question to ask whether chaebol lead the industrial policy or the government lead the industrial policy.

Anyway, that was the strategy before the crisis, the very close collaboration between the chaebols and government was one of the strengths in Korea in promoting the growth, but at the same time, structurally when things go bad, it can be a weakness. That’s my point. After the Asian financial crisis and through the IMF program, voluntarily or involuntarily, we need to adopt international best practice, and the bank has to be more independent. The old tradition started to be changed.

Then the perception before the crisis, most Koreans believed that the government is omnipotent. Basically, the government can manage the economy very well. It should be the government that lead the economy, but after the financial crisis, if there’s one lesson the Korean people in the street learned is that government is not that omnipotent. That kind of perception really contributed to rebalancing the controlling power from private sector versus public sector, and then Korean economy became much more like other economies in the other world. Korea became much more in line with the international best practices.

Nicholas Borst:

Can you talk about the role the IMF played during the crisis? The initial IMF plan to support Korea was the largest the fund had done at that point, yet it didn’t seem entirely to be able to calm the financial market panic, and it actually generated pretty strong domestic reaction in Korea. I was wondering if you could give us an overview of what the plan was, and whether you thought it was actually sufficient.

Changyong Rhee:

I think we may need 10 hours of discussion, still a live discussion. I don’t know that I can summarize quickly, and also this is a really, really controversial issue. The Fund also has learned a lot in my opinion. Many of the Fund’s current policy are also influenced by the lessons, in pros and cons, lessons we probably learned during the Asian financial crisis.

I believe IMF program, in general, played a very important role in Korean adjustment process. First one is that it really contributed to restoring confidence and stabilizing the financial market, especially in FX market. By the time when Korea approached IMF, the value of the currency was plummeting. The reserves level was extremely low, so the first order of business was to restore the confidence in the currency, and that requires increasing high interest rate policy, even temporary, right?

Even though the high interest policy definitely had a negative impact on the situation of the weak bank and corporations, once the confidence was resorted the interest rate can go back to normal levels. That controversy is there, whether how soon they had to reverse this high interest rate policy, but in general, I think there is a general agreement that the high interest rate policy was inevitable to restore the FX market stability, despite some cost.

I think fiscal policy was much more controversial. At the outset, I think that Korea needed to strengthen their position to finance the future cost of financial restructuring and also to reduce the current account deficit. Initially, the fiscal stance was tightened, and then a few months later it had risen again, eased again the fiscal stances. In retrospect, I think there is a debate from the beginning whether the IMF program needed fiscal tightening, because Korea has entered the crisis with a relatively strong fiscal position and low public debt. IMF could have done more to counteract the decline in private demand, which was driven largely by the de facto crisis on banking and corporate balance sheet.

Then also now we know how important to get social kind of endorsement of the program and the country’s ownership, so fiscal policy could play better to protect to poor and to build a social consensus for the reform. The role of fiscal policy I think is doing the assistance process, especially for a country in Asia who had maintained a strong fiscal stance, I think it was a lesson that IMF has learned. The fund learned these lessons, and now I think in most of the IMF fund program, I think this aspect especially helping the poor, and building the social consensus for structural reform – I think — are now well incorporated in the design of the current fund program.

On the other hand, I would say the fund program has really contributed a lot, and real benefit of the fund program comes from the structural side, such as a financial sector restructuring, corporate restructuring, chaebol reform, capital account liberalization, labor market flexibility, and also all this new data reporting system, which make Korea much more transparent.

I think we don’t have time to go into the details, but I think for example if Korea didn’t have a crisis at the time, I wonder whether Korea’s old system of direct lending and the government’s strong heavy hand on many managing the banking sector, I don’t know whether this could have been changed easily without having any other crisis. It’s a hypothetical case, but I think thanks to the last of structural reform, I believe also the experience of crisis management at the time, is definitely a major contributor why many Asian economies, including Korea, could remain relatively robust during the global financial crisis in 2008.

In sum, I think yes, there are many facts that some of the Asian countries can complain about the IMF program, but also there are many elements that the IMF program contributed to structurally changing the economy and making them more resilient to the global economic crisis in 2008.

Paul Tierno:

I know that you’ve written a book about bond market development in Korea. Can you talk about this and other reforms that the Korean government took after the Asian financial crisis and after the IMF program?

Changyong Rhee:

Yeah. As I said, Asian economies, the one key characteristic of Asian economies is their banks dominate the financial market structure. After the crisis, when banks failed, and with the introduction of new banking regulations, when banks significantly cut their intermediary roles, virtually all economies were stopped in Asia.

I think it’s Paul Volker, when Paul Volker once mentioned that the situation is as if riding a motorcycle with a flat tire. It is better to have a bicycle he said, so that is why Asian economies decided to develop capital market, not just for the banking sector, in particular the bond market, to help with the crisis.

Immediately after the Asian financial crisis, Asian countries led new initiative such as the Asia Bond Market Initiative. There are many other reasons why the bond market development was also urgent, because the government urgently need to raise a huge volume of public funds to finance restructuring, money needed for restructuring, and also the deficit to boost the economy.

Also, corporate restructuring and NPL resolution from the bank made it necessary to introduce asset backed security systems and also securitization law, all kinds of things.

That at first facilitated the development of corporate bond market too. In Korea, corporate bond market in terms of size was quite big even before the crisis, but they were virtually disguised bank loans, for the bank to circumvent the regulation, which prevent certain bank lending to the corporations. They actually issued the bonds, the corporation issued the bonds the bank holding it, but it’s something like, same thing as bank loan without any liquidity. After the financial crisis, I think the real developmental corporate bond market also started.

As a consequence of this, I think now the Korea bond market, in particular government bond market developed quite quickly and it supported the recovery and the structural reform during the adjustment process.

I think that kind of trial and error, taught Korean authorities that capital market development without proper infrastructure such as rating agencies, good regulation kind of things is as equally risky as ill managed banking sector. They learn a lot of lessons in this trial and error process, but the experience and this trial error process made Korea’s financial market now more diversified, sophisticated, robust, and more knowledgeable about the global financial market.

Nicholas Borst:

You’ve worked on these issues in a variety of different roles, as an academic, as a government advisor, working in a variety of different international institutions. Has this experience with these different types of organizations, changed your perspective on dealing with financial crises?

Changyong Rhee:

Surely. I think I was quite lucky to have this diverse experience. Each experience was unique and broadened my understanding of the world. As an academic, I had time, actually, I would say I had the luxury of time to focus on key few fundamental issues such as the cause and history, and how to model this financial crisis. I had lots of time to read the books, and so I enjoyed it.

As a government official, I find that different skills and responsibilities were requested. You need to know how to do the emergency surgery while your patients are bleeding, and you may have no luxury to review your theory behind it, even though you have to do the surgery. You cannot choose your patient. When I was professor, I can pick up the favorite topic, if I don’t like the book, I can throw them away, but I think as a government official you have no other choice. Whether your theory is right or not, you should have reasonable judgment to do the emergency surgery. That was a kind of skill that I observed that is quite different from what I have seen in academics.

While working in an international organization such as ADB and IMF, I had a chance to compare cross country experiences and then learn diverse perspective from creditors versus debtors, advanced versus developing countries, and how I have to compromise geopolitical issues with our mandate as an international organization. I feel very lucky to have all these rare opportunities.

Paul Tierno:

Finally, what are the enduring lessons you take from the Asian financial crisis? Looking forward, what do you see as some of the largest risks facing Asia today?

Changyong Rhee:

I think there are many lessons that we can learn from in Asian financial crisis, but I think it’s how to manage the exchange rate and open economy. Especially exchange rate system, and also capital flows. I think that when your financial market develops, definitely you need to have a more detailed knowledge of how to handle this open financial market, and understanding macro financial linkages is essential in preparing and coping with a crisis. That was a big lesson that I learned.

As for the risk at this moment in Asia, I think I would rather say today Asia is much stronger than compared with the period of the Asia financial crisis. Growth rate is higher, Asia is leading the global growth, and their resilience is much better in many aspects. Having said that, I think that one short term risk that I’m thinking at this moment is relatively high leverage whether it’s for corporate or household in Asian countries combined with low profitability of corporate sectors. After the global financial crisis in 2008, many Asian economies rely also heavily on expansionary fiscal and monetary policies to cope with the global crisis. Currently the credit and the leverage growth rate were quite high in many countries, so I believe that it’s time for them to rebuild buffers to cope with another maybe future downside event.

Another short term risk I can think about is more like inward looking and anti-trade sentiment of major economies, because Asia’s growth model heavily depends on trade and slow growth will have a much more negative impact on Asia. Specifically I’m more concerned on the medium turn risk and the short term financial crisis risk. By medium term risk, I think one risk I’m thinking about is the risk of growing old before becoming rich.

You know that Asian economies at different stage of the aging dynamics, some have already aged like Japan and Korea, and some are currently enjoying demographic dividend in India, and Indonesia, and Philippines. One common factor across these countries is remarkably fast aging speed. It’s the speed of aging’s quite fast, even you are currently enjoying the mode of dividend.

As a result Asia faced the risk of becoming old before becoming rich, and one of our studies actually compared what will be the per capita income levels compared to the United States at the peak of the working age population in these Asian countries. The result is quite remarkable. In most of OECD countries, when they reach the peak of this working population, their income level is around 80% of the US income level. Japan, Korea also achieved that levels, but for most of the other Asian economies, when they reach this peak, and some of them have already reached the peak, the income level is quite low. For example, China’s income level is 20% of US when they reach the peak of this working population. Vietnam is only 10%, and most of the Asian economies will be less than 40%.

There’s a serious risk that Asian countries will become old even before becoming rich. With these low income levels, Asian economies will find it more difficult to build up foreign assets, key health and social infrastructure, and social safety net for elderly in preparation for aging society. To make matters worse, I think productivity growth in Asia is very unlikely to help this problem, because we have an evidence that Asia have been growing fast in terms of income, but there is no evidence of productivity catching up in Asia. If you believe the history, I don’t think that fast productivity growth rate in Asia will solve these headwinds from the aging trend.

Basically in the medium term, how to cope with this fast aging trend, and boost the productivity growth differently from the past, should be a key challenge for Asia and I believe Asia policy makers should not be complacent despite the Asia economies’ stellar growth in the last 10 years.

Nicholas Borst:

Thank you so much for joining us, definitely some challenges in the medium term to keep an eye on.

Paul Tierno:

Thank you very much.

Changyong Rhee:

Thank you.

Paul Tierno:

We hope you enjoyed today’s conversation with Changyong. For more episodes like this you can find this on iTunes, Google Play, and Stitcher. For even more content look up our Pacific Exchange blog available at Thank you for joining.