Private Inflows when Crises are Anticipated: A Case Study of Korea

Introduction The Korean crisis in 1997 illustrated again the fact that large capital inflows can be a mixed blessing. Liberalization of the capital account in Korea was associated with massive private capital inflows totaling about $120 billion from 1992 through mid 1997. The reversal of these flows in the second half of 1997 and throughout 1998 was even more dramatic and generated a devastating downturn of the economy. Why did capital inflows following liberalization turn out to be so dangerous? Although the pattern of liberalization, capital inflows and crisis has become familiar, the underlying mechanism among the three events is not fully understood. An often-raised argument is that macroeconomic risk associated with exchange rate misalignment is the fundamental cause of crises (E.g. Krugman 1979). But the Korean case adds one more counterexample against the argument along with the ERM crisis in 1992 and the Mexican crisis in 1994. In all these cases the external imbalance of the economy before the crisis was hardly alarming (e. Recently, Dooley (1998) puts forward the insurance model as an alternative explanation for the mechanics behind massive capital inflows and crisis. The basic idea of the insurance model is that the microeconomics of financial intermediation and the government's role in financial intermediation are the primary sources of crises. Crises in this framework are not related to changes in private expectations or to inconsistencies in macro regimes. Instead the policy inconsistency arises from the desire of governments to accumulate financial assets in order to smooth national consumption and the desire to insure the domestic financial system. The insurance model is particularly appealing when placed in the context of the Korean crisis. In Korea, banks were the major intermediaries of capital inflows before the crisis and indeed foreign creditors' run from Korean banks triggered the crisis in November of 1997 (See Shin 1998). Thus, in the following pages we will attempt to interpret the recent crisis in Korea in the context of this model. The analysis suggests that financial liberalization in Korea was the fundamental factor behind the crisis. Liberalization reduced the franchise value of the banking system and exposed very weak balance sheets to competitive pressures that promoted risk seeking by banks. The second problem was the failure to regulate the consolidated balance sheet of commercial banks. The failure to control foreign branches of Korean banks created an ideal vehicle for exploiting insurance. The important role …