Well before the opening of capital markets in the 1990s, liberalization and
democratization led to significant changes in Korea’s developmental state model.
However, while expectations for government protection against large bankruptcies
remained strong, institutional reforms and credible market signals (e.g., large-scale
corporate failures) designed to replace weakening government control with market-based
discipline were not introduced in the pre-crisis period.
The weakening of investment discipline since the late 1980s served as the underlying
cause of the 1997 economic crisis. Although financial globalization did not “cause” a
series of major corporate failures that preceded the crisis, it played an important role in the outbreak and resolution of the crisis. In particular, increased exposure to short-term
foreign debt made it all but impossible for the Korean government to adopt a wait-and-see approach, because it could not persuade foreign creditors to refrain from their run on
Korean banks. The international nature of the 1997 crisis, as well as its magnitude, left the
government with little option but to go to the IMF for immediate relief and address the
underlying problem of nonperforming loans.
The crisis also had the effect of weakening the political clout of vested interests, which
otherwise might have blocked reform. A newly elected reformist president took
advantage of the crisis atmosphere to push major bills through the National Assembly,
even though his coalition did not have a majority. Endorsed by international investors as
well as non-governmental organizations campaigning for shareholder value, his reform
initiative, in turn, strengthened market forces and made it increasingly difficult for the government to “suspend” bankruptcies and backtrack on reform. In addition, the absence
of controlling shareholders at commercial banks helped to make large-scale financial sector
restructuring a politically viable process, at least in comparison with other countries.
The most critical role played by foreign capital in Korea’s reform process was in forcing
the Korean government to recognize losses in the form of latent nonperforming loans. Yet
foreign creditor banks and investors were reluctant to share the burden of losses, often
demanding “special treatment”; whereas, international organizations as well as analysts
advising portfolio investors supported accountability and transparency in the sharing of
losses. Also, international organizations played an important supporting role in
institutional reform to lay out a more transparent and accountable financial system while
foreign direct investors introduced significant changes in business practices.