Korean Uncertainties:
Economic Crisis, North Korea

The Korean Economy
Korea was one of the early countries into the crisis, in late 1997. I arrived as Ambassador on the same weekend in late November as the IMF team. When I agreed to go to Korea, I did not think I was going to have to deal with a full-blown financial crisis. My attention was focused toward the North. In fact, the great bulk of my time over the first year has been spent on dealing with the economy and trying to support Korean efforts to reform, restructure, and recover.

The origins of the crisis in the case of Korea are, with the great advantage of hindsight, quite obvious. Korea had a very weak and poorly regulated—in fact, not regulated at all—banking system that found its balance sheets loaded with a lot of short-term foreign obligations. They had been funneling that money into the Korean corporate sector, where it was applied to finance long-term projects, and not very good projects for the most part. When the panic began in the second half of 1997, foreign banks began demanding repayment or at least not rolling over loans that were coming due, and the financial structures of the country began to crumble.

This was the most immediate manifestation of the problem, and the United States, together with the IMF and others, put together a financial rescue program which was designed to address the foreign exchange crisis—the largest bailout in the history of the IMF, some $57 billion. That began to work fairly satisfactorily in early 1998 as the external financial situation began to stabilize; and now, a year later, the Korean won is back up to a reasonable level of around 1200 won to the dollar, having recovered from almost 2000 won to the dollar in early 1998. Foreign exchange reserves are now comfortably over $50 billion. They had been less than $4 billion at the end of 1997.

So the external financial situation has stabilized. Korea is again investment-grade rated and Korea has regained access to international capital markets.

The problem of the domestic economy, however, was underestimated at the time the crisis broke. While Korea has made substantial progress on it, I think there is still a lot remaining to be done.

The Korean government has moved to strengthen the banking system. It has forced mergers and closed a number of banks. The government has put about 15 percent of GDP into a recapitalization of the banking sector. And the government has moved very vigorously to try to establish a system of prudential supervision of the banks, to make those banks behave more like banks should behave. Traditionally banks in Korea were really part of the official bureaucracy. They were the funnels through which cheap credit was channeled by the government to the major chaebols for identified projects in priority sectors. The banks had no acquaintance with the fundamentals of credit analysis. The word “creditworthy” was not heard a lot in South Korea until this past year.

The major corporations, known as the chaebols, were highly leveraged—debt/equity ratios in some cases were nearly 10/1—with a mountain of domestic debt. Domestic debt was a far greater problem in many ways than foreign debt. A forced restructuring of the corporate sector is underway with differentiated results. Some of the smaller and medium-sized chaebols are pretty much through a very severe debt workout process and have put themselves in a position where, conceivably, they could begin thinking about new investment. However, the Korean economy is dominated by the top five chaebols and while a couple of those have made some progress in reducing debt/equity ratios, restructuring, and slimming down, some of them have also continued to resist this new reality.

Korea, in retrospect, benefited greatly from what at the time was seen as a disaster-the fact that they had a presidential election in the early weeks of this financial crisis. When I first arrived two weeks before the election, people were saying, “Oh, it’s just awful that we’re going to have a presidential election; there’s tremendous political uncertainty; how are we are ever going to deal with this economic crisis that we suddenly find ourselves facing?” Two weeks later, after Kim Dae Jung was elected and warmly embraced the IMF program and began vigorously pushing—even before his inauguration—a program of across-the-board reform and restructuring, people began saying, “Aren’t we fortunate that we have had an election?” As it turned out it was very fortunate. Kim Dae Jung was able to avoid having to defend the policies of the previous government. Over the years he had developed his own approach to the Korean economy, which as it turned out was very congruent with the IMF approach. Basically, from his point of view, this was a program designed to break what he considered to be the stranglehold of the large chaebols on the Korean economy. But in so doing he has also begun to open up the Korean economy to a degree that I think most people who have watched Korea over the years would scarcely have believed possible. Korea is now welcoming of foreign direct investment, in fact, is out recruiting foreign direct investment. In 1998, Korea had commitments of over $8 billion. That’s more than the accumulated commitments of foreign direct investment in the preceding seven years. The government hopes to double that in the year that is presently underway.

So, the Korean economy—when this crisis is finally behind them—will be far different and, I would judge, far stronger than it was going into the crisis.

Now, the Korean people paid a very heavy price. GDP was down about 6 percent last year. Unemployment is at levels that Korea has never had to sustain. And the prospect of labor market instability and labor agitation remains a concern. But Korea is now in a position where, by the end of this year, it could begin to record some modest real economic growth.

That may be somewhat optimistic. It is not as optimistic as some forecasts, which estimate growth at 2­4 percent in the course of 1999. I find that a little difficult to credit, since I do not see where that new demand is going to come from within the Korean economy. Given the international economy, Korea is unlikely to be able to improve this year on last year’s export performance by enough to turn negative growth numbers into positive ones. Domestic private consumption is still very depressed. (The Koreans, reacting to the threat of unemployment, basically stopped spending. Private savings levels, which were always high, have now gone up as far as 40 percent. This has had a very depressing effect, as you can imagine, on the business cycle within Korea.) The prospects for a surge of corporate investment remain, in my judgment, fairly low because the major chaebols have not yet worked themselves through a restructuring process sufficiently for their balance sheets to support any sustained new surge of investment. Government spending is up and will remain up. But overall it is hard for me to see how Korea is going to record more than modest growth in the course of 1999.

Now my Korean friends tell me I'm probably wrong. They say this is an economy which cools down very quickly, but which will also heat up very quickly. I hope they are right. East Asia badly needs some country that’s growing. East Asia would benefit from a recovered Korea.

As I look into the next year, there are a couple of things that worry me. One is complacency. Not everyone in Korea yet shares Kim Dae Jung’s vision as to the shape of the Korean economy of the future. There are strong forces within the bureaucracy and within the chaebols which are simply waiting for a decent interval to pass when things will then revert to the way they used to be. I do not think a reversion is likely to happen. But there is a substantial risk that this attitude will cause the reform and restructuring process to slow down-slow down very dangerously.

Labor unrest would also be quite destructive of any prospects for growth. Korean unemployment is now around 8 percent. If the chaebol restructuring proceeds as it should over the next year, unemployment is in all likelihood going to grow somewhat. It will grow because workers, mainly unionized workers in the large chaebols, are going to find themselves out of jobs. I have been pleasantly surprised over the past year by the government’s success in maintaining a degree of social calm in the midst of this tremendous economic turbulence, and I hope Kim Dae Jung can continue to do that in the year to come.

Another threat to Korea’s economic recovery, of course, is international. Korea does not exist in an economic vacuum. You all are familiar with forecasts for Japan. I think China is a subject of increasing concern to Korea in the year to come, and the outlook for the rest of East Asia does not look all that bright. So continued economic stagnation in the region, combined with the possibility of more financial instability in emerging markets, could at some point pose a serious threat to Korea’s economic progress. But I would stress that so far Korea has been very successful in differentiating itself from other emerging markets. The Koreans have done that on the basis of their performance. They have carried on with strengthening the banking system, establishing prudential supervision, corporate restructuring, opening up the economy, and reducing barriers not only to foreign direct investment, but foreign investment of all kinds. Korea is now by and large a remarkably open economy, especially for capital flows, although some serious market access problems remain in the area of trade and services.

North Korea
Let me talk for a few moments about the situation with regard to North Korea. We have had a rather curious reversal of roles on the part of South Korea, the United States, and Japan. When I first started at KEDO [The Korean Peninsula Energy Development Organization] in 1995, the United States was seen to be forward-leaning. We wanted to do things with North Korea. We wanted to get KEDO up and running and build these reactors. We had just concluded the Agreed Framework in 1994, and we felt we had some momentum. South Korea, on the other hand, felt in their heart of hearts that the Agreed Framework was a purely American invention, that it was designed to meet American interest and had very little to do with South Korean interest. Most of our time was spent trying to convince the South Koreans to move forward and create KEDO, negotiate the basic agreements with the North Koreans, and begin putting money into the enterprise.

Japan was probably closer to the United States at that point than they were to South Korea in terms of a willingness to see KEDO and engagement with North Korea evolve. That has all changed. The major reason is that South Korea’s policy has changed in a very dramatic fashion. With his election as president, Kim Dae Jung embarked very early upon what is now popularly known as the Sunshine Policy—going back to the old adage that if you cannot make a man take off his coat by blowing a cold wind at him, bury him in sunshine and then he will take the coat off.

Kim Dae Jung has enunciated three principles which guide his policy. His first principle is that Korea will not tolerate any military provocation, which is another way of saying that the alliance with the United States remains one of the cornerstones of South Korea’s policy toward the North. The second is that Korea will separate business from politics, which is a way of saying that he is prepared to unleash the South Korean private sector and allow corporations to go to the North and invest. Now we should not misunderstand that this signifies that South Korean corporations have been straining at some leash down in the South, eager to go north and not allowed to do so by previous governments. For the most part they have not been straining.

The third principle is that Korea does not seek to undermine or absorb North Korea. This is a fairly fundamental shift in South Korean thinking from that of the last four decades. This principle is really saying that Korea wants to try to arrive at some general level of reconciliation and avoid the collapse of North Korea. South Koreans have been very impressed by the difficulties that Germany has had in dealing with reunification; and their lack of enthusiasm for having to deal with their own reunification, of course, increased dramatically with the onset of their economic crisis. The necessity to cope with these two things simultaneously would strain them very much. So basically they are trying to bring about a situation in which gradually, over time, North Korea and South Korea decide that they can afford to live together in greater harmony on the Korean Peninsula.

Conservative South Koreans fear that as soon as they stop regarding North Korea as an implacable enemy, set and determined to assault them at the first opportunity, South Korea will lose its moral fiber, its guard will fall and they will in fact be vulnerable. I think that is not terribly likely, but that is the approach that opponents to Kim Dae Jung’s Sunshine Policy take. So South Korea has gone from being a reluctant participant, at best, in dialogue with the North to being the champion of dialogue and engagement.

The United States has gone from being the only forthright champion of engagement with the North to a position now in which—largely because of differences between the executive branch and the Congress—we find ourselves having difficulty in keeping up with South Korea and its engagement policy. The New York Times story last summer saying that our intelligence had revealed a large underground site being constructed in North Korea, a site which, it was suspected, would be used to house a nuclear reactor and possibly a reprocessing facility, caused an immediate explosion in the Congress. That story was followed two weeks later by the North Korean launch of a Taepodong-1 missile which they had the bad grace to fire right over Japan. That launch, of course, evoked a very strong reaction from the Japanese, who, knowing what North Korea’s real opinion is of Japan, were not very comfortable with the notion that North Korea could reach out and touch them with that kind of a missile should they ever so desire.

We Americans have our problems with our Congress, which I am confident we will resolve over the next few months and be able to move forward in meeting our financial commitments to KEDO. We have South Korea eager to move forward, but with internal conflict over this policy. And we have Japan very distraught and very conscious of the fact that, if there were another missile test, their ability to continue to support KEDO financially would be diminished and could be destroyed.

North Korea itself is, of course, the subject of everyone’s attention, but it remains an enigma. We know so little about what is going on within North Korea. We know more than we did a couple of years ago because there are more people and agencies going in and out of North Korea. I think it is without question that North Korea is in a decline, and I believe it is in an irreversible decline. If you take 1992 as a baseline, most analysts would agree that the economy is currently at about a 15 in relationship to the 100 of 1992, in terms of industrial production, energy production, all of the standard benchmarks of economic performance. Its inability to feed its population is very well-known outside North Korea and is the subject of endless appeals for humanitarian assistance.

As North Korea’s economy has deteriorated, North Korea has seen its conventional arms capability erode as well, although it is still formidable. North Korea has moved, we believe, to a greater development of what military strategists call asymmetrical forces—namely missiles, possibly a nuclear program, and chemical weapons, all of which are designed to offset the erosion of their conventional military capability. In the medium term, however, I am still most concerned about their conventional military capability in that it poses a direct threat to Seoul. They have several hundred artillery tubes that have Seoul well within range. When people in this country, including in our Congress, begin talking about responding to the problem of this suspicious underground site by throwing a few cruise missiles in there, I think we all ought to stop and reflect that this is not Iraq. The North Koreans have the ability within minutes to retaliate in a very fearsome fashion on Seoul, and I think most of us conclude that they would not hesitate to do that if they were the subjects of a pre-emptive strike themselves.

As we look out over the next year, we should be able, with energy and imagination, to weld ourselves together with the South Koreans in a policy very broadly designed to create for North Korea the possibility of electing to live in a somewhat different world from the one they are living in now and to offer them the possibility of greater engagement, primarily economic engagement with South Korea and, to some extent, the United States. We have some cards to play. We have, of course, continued to supply food aid. We also have had some economic sanctions in place since the Korean War which are, in my personal judgment, much more important in terms of North Korea’s perception of our relations than they are in terms of North Korea’s economy. The release of these sanctions would not suddenly give them a great economic boost, but politically, they are very important.

South Korea, of course, has a number of carrots and incentives that they can put on the table. They have the Kumkang Mountain tourism project that Hyundai has put together, which is a source of revenue for the North Koreans. I think there are other South Korean companies that would be prepared to put resources into North Korea with some government encouragement. All of this in my judgment is good because these points of economic inter-connectedness between North and South create a North Korean self-interest in not doing bad things on the Korean Peninsula. The connections tend—in their accumulation—to tie North Korea down a bit.

Long term, it is very difficult to construct a scenario in which North Korea continues to survive, barring a massive change of policy and direction, which I personally am not confident they have the capacity to do. The South Korean Sunshine policy is based on an assumption that one can induce change in North Korea. It is not that we simply buy North Korea’s change, but that we change the external conditions surrounding North Korea. North Korea is relieved of what South Koreans argue is its siege-like mentality by providing assurances of non-aggression, assurances that we will not try to overthrow it. Eventually over a period of time, North Korea is tamed to the point at which internal change can occur. It is a very sophisticated argument and it is very difficult to refute in the abstract. I am personally of the belief that we should try it. I do not think it is a high-risk or a high-cost strategy. The main risk is a political risk to Kim Dae Jung. He is the one who would lose if this policy does not eventually succeed. Korea, too, would lose.

There have been some encouraging signs, such as the Hyundai project and a recent proposal from the North for North-South talks. Although heavily conditioned on such things as removal of U.S. troops, I think this proposal is probably, in fact, less conditioned than similar offers have been in the past.