Economic Growth Controlling Capital focusing on the 1960s ：经济增长的资本集中在20世纪60年代的控制

Economic Growth Controlling Capital focusing on the 1960s ：经济增长的资本集中在20世纪60年代的控制 Economic Growth Controlling Capital: focusing on the 1960s’ experience in Korea Kang-Kook Lee (Ritsumeikan University) Abstract The political economy of capital controls, liberalization and crisis in Korea are examined from institutional and historical perspectives. We analyze how capital controls helped economic growth under the developmental state. The experience with capital controls in Korea points to the importance of the specific institutional structure for success. We then examine the process of the demise of the developmental state and the mismanaged process financial liberalization and financial opening. We describe the change in the financial system and the government-business relationships. The broad change of institutions and liberalization led to serious vulnerability in the economic system and the financial crisis. After the crisis, the government introduced further opening as part of neoliberal economic restructuring. This raises concerns of foreign dominance, lower investment and higher instability. The Korean experience demonstrates that it is essential to consider the broad issues of political economy in order to understand the effectiveness of and changes in capital account regimes. Key Words: Capital Controls, Capital Account Liberalization, Financial Crisis, Economic Restructuring, Korea JEL Classification: O16, O53, P45 I. Introduction The Korean economy was awe to economists in many ways. It was applauded as an economic miracle for its great economic growth. Thus, there have been lots of studies on this success. Recently the 1997 economic crisis triggered another hot debate about the cause of the Korean economy. In understanding the Korean success and crisis, it is very important to study the foreign capital management policy. The miraculous growth was based on the strong capital controls, and the crisis was mainly due to the careless financial opening policy. In this study, we examine the Korean experience of the foreign capital management policy in the 60s’. In fact, the dominant mainstream argument is that liberalization and opening of the market provides the economic success and the liberalization is recommended to all over the world. However, it is not clear about the financial market. Still most empirical studies report that there is no evidence that capital account liberalization spurs growth in developing countries. Rather, capital account liberalization tends to cause instability and in some cases, capital controls may help economic development like in Korea. Thus, more extensive study about the case of capital controls, in particular about how it can be helpful to the economy, is called on. In this regard, the Korean experience of capital management is very interesting. Based on the specific institutional structure of developmental state, the government successfully implemented the controls as one of important part of the development strategy. This paper consists of 4 parts. In the first section, we examine the current arguments about capital controls, we review the mainstream and heterodox arguments and show how capital controls may help growth under some conditions called the developmental state. The next section deals with the institutional structure of the developmental state such as the specific government-business relation and state-led financial system. We examine the experience of foreign capital management in Korea in the third section. The strong capital control regime was established as early as in the 60s’ and continued up to late 80s’, however the government was also active to encourage foreign borrowing with its guarantee. We study how specific institutional structures and political economy are interrelated with the successful controls in the 60s’ in Korea. Also, we shed important light on how the controls are related to other policies such as the industrial policy and domestic financial controls for economic development. In so doing, we can get important lessons of the capital controls policy for other developing countries. II. Political economy of capital controls, decontrol and economic development 1. Capital account liberalization, controls and economic development (1) Pros and cons of capital account liberalization and controls Mainstream economists emphasize gains from the international capital movements made possible by capital account liberalization; their arguments are base on belief in 1efficient markets. They argue that the integrated global financial market enhances efficiency in resource allocation, reduces the costs of intertemporal misalignments and helps investors diversify risks. They also maintain that liberalization and international capital movement increase the availability of foreign savings to supplement domestic capital in the host country, and thereby encourage investment (Guitian, 1997; Edwards ed., 1995; Prasad et al., 2003). In addition, the international capital market disciplines national governments and liberalization reduces budget deficits (Kim, 2003). According to these arguments, capital controls limit the opportunities afforded by the international market, restrict financial market competition, and introduce distortions and inefficiency (Dornbush, 1998). They are both inefficient and ineffective because in most cases private capital can evade these controls (Edwards, 1999). However, these arguments are valid only with the assumption of an ‘efficient’ financial market. It is hard to support efficiency of markets either theoretically or empirically. Financial markets suffer from serious market failures due to information problems, with investors displaying ‘herd’ behavior (Luxx, 1995; Kim and Wei, 1999), and they are rife with moral hazard problems, giving a rise to ‘overborrowing’ or ‘overlending’ (McKinnon and Pill, 1999). Furthermore, from the perspective of the ‘theory of the second best’, the benefit of liberalization is hard to justify coexisting trade barriers and differential tax rates (Brecher and Diaz-Alejandro, 1977; Bhagwati, 1998). Financial opening may generate more instability, aggravating boom-and-bust cycles and concentrating risk, rather than diversifying it. In fact, recent financial crises are 1 For an extensive survey on the debate about capital controls, including neoclassical arguments, see Rajan (1999) and Cooper (1999). explained by self-fulfilling expectations models with strong contagion effects transmitted through the international financial market (Eichengreen et al., 1997). Faced with the critique that financial opening may destabilize the economy, economists point to the importance of several preconditions and proper sequencing for the success of liberalization (McKinnon, 1991; Williamson and Mahar, 1998). Successful capital account liberalization needs macroeconomic stability and the establishment of a sound financial sector with a strong supervision system, and it should be developed gradually, only after trade liberalization. This so-called ‘orderly financial opening’ rubric has become the new conventional wisdom (Eichengreen and Mussa, 21998; Fischer et al., 1998). However, although these economists recognize the importance of regulation and institutional development, their main thrust is still toward liberalization. They underestimate problems of international financial markets and the limits of national regulation following opening. Setting up prudential regulation in developing countries takes years, and even developed countries with relatively good regulation suffer from crises (Rodrik, 1999). Moreover, it is not easy to distinguish between capital controls and prudential regulation since prudential regulation also limits the free capital movements. Hence, more skeptical views have prevailed recently. In particular, after the Asian crisis in 1997, many prominent economists have argued that the crisis was due to careless financial liberalization and opening, and called for controls over short-term capital flows (Furman and Stiglitz, 1998; Radelet and Sachs, 1998; Krugman, 1998). However, it should be noted that they remain focused on the volatility of short-term capital, and do not examine capital controls in the broader context of management of the economy and the development process. To resolve this controversy, a large number of empirical studies have been done recently. They show only mixed results; there is no strong evidence that capital account liberalization spurs economic growth (Prasad et al., 2003). (2) Capital controls, economic development and political economy 2 These economists even say temporary controls to restrain speculative short-term foreign capital are not incompatible with a broad process of capital account liberalization in this respect (Eichengreen et al., 1999). Heterodox economists understand capital controls and liberalization in relation to the broader context of economic management and growth. They argue that controls are helpful to implement full employment and egalitarian policies. National governments may lose policy autonomy under an open capital market because of the possibilities of capital outflow and currency attacks (Crotty, 1989). The ‘golden age’ of capitalism was based on capital controls that enabled the adoption of Keynesian macroeconomic management and the promotion of economic stability (Helleiner, 1994). Financial globalization, starting in the 1980s, has made it harder for countries seeking full employment to manage their economies, and has done harm to workers with a threat of capital outflows. Heterodox economists argue that capital controls, if effectively adopted under a proper development strategy, can be an important tool to promote national economic development in developing countries. In particular, they emphasize political will and the 3feasibility of controls in practice (Crotty and Epstein, 1996). Historically, developing countries have kept controls for various reasons, including avoiding balance of payments problems and ensuring macroeconomic stability (Johnston and Tamirisa, 1998). The experience of East Asian countries deserves special attention with regard to the important role of controls for growth. They achieved rapid development with strong capital controls that worked in conjunction with credit controls and national developmoent plans (Nembhard, 1996). Proper capital controls may spur growth through several channels. First, controls can keep capital in the domestic economy and hinder capital flight, which can increase domestic savings and investment. Several African and Latin American countries have suffered from huge capital flight (Ndikumana and Boyce, 2002). One may argue that controls repress capital inflows that are necessary in the early stage of development, but this is not self-evident. For instance, selective controls may change the structure of foreign capital inflows towards longer term so as to encourage economic growth, as in the case of Chile. A proper management of foreign capital, such as guarantees for 3 Mainstream economists argue that controls over outflows mostly failed and controls over inflows are not very effective (Edwards, 1999). However, recent extensive case studies show capital controls are indeed successful in some cases and need not have significant costs (IMF, 2000). The experience of capital controls that were implemented effectively in Chile and Malaysia in the 1990s support heterodox economists. 4foreign debt, may encourage foreign capital inflows. Foreign investment is indeed more affected by the country’s growth potential rather than by regulation itself (Mody and Murshid, 2002). Capital controls are likely to maintain foreign reserves, allow for the manipulation of the terms of trade for trade growth, and, most importantly, stabilize the economy, thereby further boosting economic growth (Ramey and Ramey, 1995; Prasad, et al., 2003). Measures to regulate foreign direct investment (FDI) may be also needed for the growth of domestic firms and autonomous national development. Though FDI is said to be more beneficial than other flows, some regulations are essential to reap the spillover effects and acquire advanced technology and modern 5management skills (Mardon, 1990). Of course mere controls are not a sufficient condition for growth; it is necessary that controls be incorporated in policies designed to promote productive investment. Thus, they should be coordinated with appropriate efforts by the state in capital allocation 6(Stiglitz, 1994). While financial liberalization in developing countries usually fails to promote long-term investment and growth, effective financial control can achieve success, as seen in East Asia. (Dimitri and Cho, 1996; Hellman et al, 1997). Capital controls were an essential part of the state-led financial system that mobilized capital and allocated it into priority industries. However, financial and capital controls may hamper growth, unless rent-seeking and corruption are minimized in the process, as seen in the failure of intervention in other countries. In fact, the East Asian success was in large part due to an institutional structure called the developmental state (Evans, 1995; Louriax et al., 1997). We examine this specific context and political economy in which capital controls can be successful in the next section 4 In this regard, capital controls must be understood in a broader sense and the term, ‘foreign capital management policy’ could be more relevant (Epstein, Jomo and Grabel, 2003). 5 Some studies show that FDI spurs growth in developing countries under some absorptive capacity such as the higher level of education (Borensztein et al., 1998; Bosworth and Collins, 1999). However, others studies refute this and microeconomic studies to analyze ‘spillover effects’ show only mixed results (Carkovic and Levine, 2001; Aitken and Harrison, 1999. For a survey, see Hanson, 2000. Some even argue that the share of FDI is higher in riskier countries with less developed institutions (Hausmann and Fernandez-Ariase, 2000). 6 Since Gershenkron emphasized forced saving to encourage investment, the government role has been at the center of the debate (Gershenkron, 1966). Mainstream economists have long criticized financial repression but a recent theory of financial restraint points to the positive role of government regulation on interest rates and entry in banking. It can promote financial deepening by creating a rent that is beneficial to growth and stability (Stiglitz and Uy, 1996; Cho, 1997). 2. Political economy of capital controls and decontrols (1) Developmental states and capital controls The institutional structure was crucial to economic growth in East Asia. Opposed to neoclassical arguments emphasizing free market operations (Balassa, 1988; World Bank, 1993), heterodox economists stress the important constructive role of the state. They point to several active government policies that were essential for the success of the region, including the selective promotion of industry, credit allocation programs, various trade protection measures, and capital controls (Amsden, 1989; Wade, 1990; Chang, 1994). Specific institutional structures such as ‘embedded autonomy’ and high state capacity, along with a distinctive state-society relationship helped intervention succeed (Leftwitch, 1995; Evans, 1995; Ahrens, 1998). States in East Asia had strong autonomy and a large administrative capacity because no strong economic interest groups existed. A second important feature was the close and cooperative government-business relationship, and the discipline that states maintained over businesses. These mitigated information problems and limited rent-seeking (Weiss, 1998). Although not often considered, external threats and international geopolitics played an important role (Vartiainen, 1995). On this basis, the region developed a state-led financial system and developmental regime, combining market and state mechanisms in a unique way (Pempel, 1999). This system, which some have called ‘quasi internal organization’(QIO) included large enterprises and banks that operated with coordinating 7hierarchical relations based on financial control (Lee, 1992). An outward-oriented strategy played a role since export performance provided criteria the government could use to support and discipline the corporate sector, while the government simultaneously 8introduced import substitution and protection. 7 Internal organization could be efficient in handling information imperfections in that the bounds of rationality are extended due to its hierarchical structure. This removes uncertainty through coordination of decisions (Williamson, 1975). 8 Sum argues that the mode of regulation of the developmental state was ‘embedded exportism’ from the perspective of ‘Regulation Theory’ (Sum, 1997). How do capital controls function under the developmental state, and what is the interaction between them? The effective execution of controls is only possible with significant government capacity and relatively little corruption. More importantly, the growth-oriented state encourages the corporate sector to make use of borrowed capital productively by enacting industrial policies and controlling domestic finance. Foreign capital was an important source of preferential policy credit to encourage priority investment (i.e. the ‘carrot and stick’ strategy of discipline and support) (Amsden, 1989). 9Hence, capital controls worked as an essential component of the developmental state. Controls also helped the government discipline businesses because they relied on external finance and foreign capital, all of which were controlled by the government. Developmental state theory helps us understand the importance of institutions for successful capital controls in this regard. However, the ‘relational’ nature of the state and the social influence on policies should be considered further. Important aspects of institutional change or evolution have not been studied until recently (Jessop, 2000; 10Chan et al., 1998; Cho and Kim, 1998). Ironically, the success of the developmental state may engender its own demise as the growth of private businesses undermines state autonomy and international pressure to liberalize increases (Lee, 2004). The change of the developmental state and capital account regimes are another important issue that should be studied extensively. 2) Role of the government in financial market and capital controls While the liberalized financial market in developing countries fails to promote long-term investment and growth, the effective financial control does the job successfully, seen in East Asia. (Dimitri and Cho, 1996; Hellman et al, 1997). Under this state-led financial system to mobilize capital and allocate it into priority industries, capital controls were an essential part……….. 9 Domestic financial control, industrial policy and capital controls were argued to be trilogy of effective government intervention to enable economic development (Nembhard, 1996). The three must work together to be effective, and the demise of one element can make the system dysfunctional. 10 Another limit is that they think of the state as monolithic. Some point out corruptions and internal conflicts even within the developmental state (Bello and Rosenfeld, 1990; Kang, 2002). Before turning to the institutional view, we discuss the important role of the government in financial market for economic development. It has been already well acknowledged by many theorists (Stiglitz, 1994). Since the classical argument by Gerschenkron underscored so-called ‘forced saving’ essential for late industrialization (Gerschenkron, 1966), there have been so many theoretical and case studies for it. Even if financial repression theories believe that it is always bad for economic development, recently many contend a mild form of financial repression may be helpful for economic development. The financial restraint hypothesis contends that the state intervention in the financial sector such as regulation of interest rates and entry of banking, and allocation of finance, may promote financial deepening and economic growth, by creating a kind of rent beneficial for the stability of the banking system and the firms (Stiglitz and Uy, 1996; Cho, 1997). As we mentioned, financial markets are naturally incomplete because of incomplete information to raise the credit rationing, which is more serious in developing countries. Besides, long-term dynamic efficiency related to the performance of firms is more important than short-term allocative efficiency for economic development. In this regard, encouraging the stable and long-term investment is crucial for economic growth, which cannot be achieved by mere liberalized financial market in developing countries. For several reasons, the government intervention in the financial market like directed credit can be efficient, and it was true in the East Asia (Dimitri and Cho, 1996). They apply this perspective to the experiences of East Asian countries including Japan and Korea (Hellman et al, 1997; Demetriades and Luntiel, 2001). In this regard, the government should play an essential role in the financial market to overcome market failure and boost economic development. In Korea, the financial control was the most important tool for the government to encourage national development (Patrick and Park, 1994). The Korean government successfully played this role of controlling and allocating capital directly into specific sectors and firms in order to spur investment (Cho and Kim, 1997). Moreover, the government made a great effort to create a new financial market like the second financial sector or capital market to mobilize public financial resources to the fullest. In some cases, it is also the government that shifted risk in industry to financial sector based on financial control. It should be noticed that discipline mechanism over private business by the government is prerequisite for effective state controlled financial system to promote growth, as we 11already mentioned. In this system, foreign capital controlled by the government was crucial for maximum mobilization of capital and its selective allocation in line with industrial policy, when the financial market is underdeveloped and available capital is scarce. The Korean economic growth indeed depended a lot on foreign capital with huge foreign debt, but the government successfully managed the attraction and usage of the foreign capital to maximize its benefit. But although the financial control with capital controls can succeed in promoting economic development by promoting and managing investment, it could raise problems like too much burden on banks and bad capital structure of firms. Meanwhile, the initial strong government control may get weaker due to the change of financial market and the growth of business that would dominate financial market. This change of power relationship between the government and business may well lead to dismantle capital controls as private business requests more deregulation, that will give more power to capital against the state. Thus, there is a kind of interaction between capital controls and decontrol, and power relationship between the state and capital, which we will examine in the next section in terms of ‘developmental state’. 11 Demetriades and Luntiel (2001) shows that the government control over the financial system and lending rate regulation led to financial deepening in Korea from the perspective of financial restraints theory. However it should be noted that the original theory of financial restraint is based on the Japanese case and the role of the government was much more in Korea. It is essential to analyze how the control works in relation to other policies. III. Korean Developmental state 1. Institutional structure of the developmental state Nobody would disagree that Korea is a one of the best cases of a typical developmental state. The Korean government built a specific institution and financial system in which it allocated financial resources in line with industrial policies, and succeeded in spurring investment, exports and economic development (Amsden, 1989; Chang, 1994; c.f. Pack, 2001). The government was a headquarters of a company using banks like a financial department and firms were like an operation division of so-called the Korea Inc. The first character of the Korean state was strong autonomy from interest groups. Behind it were socio-historical conditions such as weakness of interest groups due to the land reform and relatively equal distribution (Leftwitch, 1994; Ahrens, 1998). The state also had relatively strong capacity thanks to the bureaucratic tradition and reform efforts, and was oriented toward national development based on administrative guidance following Japan (Woo, 1999). Secondly, though it was autonomous, it was not predatory at the expense of the whole economy, but well embedded in the society, coordinating closely with the private business (Evans, 1995; Weiss and Hobson, 1995; Weiss, 1998), and this ‘embedded autonomy’ or ‘governed interdependence’ was essential for successful intervention, by constructing a specific government-bank-business relationship. External threat and international geopolitics helped it further (Gunnarson and Lundahl, 1996; Vartiainen, 1995). The ‘Cold War’ situation made supports from the U.S possible, and the regime competition between North and South was crucial for national mobilization with a development-oriented and anti-communist ideology (Cho and Kim, 1998). The equal distribution called ‘shared-growth’ principle is also argued to contribute to preventing excess representation of demands of social groups and effective mobilization (Campos and Root, 1996; Rodrik, 1998). But we should notice that the government repressed labor strongly so that mobilization was compulsory and the embeddeness was mostly in capitalists, in particular big ones. All of these features were established in the 1960s, after the military coup broke out. The government………….. On the basis of this institutional feature, the government actively carried out active industrial policies to support priority sectors, with controls over domestic and foreign capital. The government endeavored to promote and manage investment with strong investment coordination among businesses to prevent excessive competition and encourage competitiveness (Amsden, 1989), and with industrial restructuring if needed. Big businesses grew rapidly with tremendous financial supports and guide from the government. Chaebols, Korean conglomerates with a diversified structure and centralized ownership, entered into priority industries and increased investment following the government promotion of the export and HCI sectors (Lee, 1997). They have increased competitiveness by competition in the export market, 12internalization of deficient productive factors, and disciplines by the government. The government made a cooperative and disciplinary relation with them, with the intimate consultation through the deliberation council and the support in return for the export 13performance (Fukagawa, 1997). Though the internal corporate governance and monitoring by the financial market was weak, the government itself monitored debt- 14ridden businesses, controlling banks (Nam, 2001; Chang, 2003). Meanwhile, banks were in effect agencies of the government to implement policies to mobilize and allocate capital under strong regulation, and help from the central bank. Their management autonomy and monitoring through loan examination were limited, but it was ok as long as the government control was effective. Based on this government-bank-business relation the developmental state worked well, at the center of the whole process was financial control. 2. State-led and bank-based financial system 12 Government’s discipline mechanisms are found in several cases. They include the export loans exchanged for the export performance, the rigorous examination of investment project in the HCI program, the regulation to make the firms in the import substitution industry supply materials for the export industry at the international price, and various state-led merger programs. Most of them were implemented with financial measures. 13 The state intervention was not to replace the market but to build specific institutions compounding the state and the market mechanism. This mechanism is called ‘contest’ mixing competition and test (World Bank, 1993; Aoki et al., 1997). 14 It was easier since they relied on external finance a lot, called ‘high debt model’ (Wade and Veneroso, 1998). The debt ratio in the manufacturing sector increased so fast from less than 100% in the early 60s’ to over 300% in the early 70s’ and it continued high over 300% up to the 1997 crisis. The control of the financial sector is key feature of the Korean developmental state, and crucial to understand success of capital controls. Since the early 60s’, the government adopted various measures to control finance including the takeover of the monetary policy from the central bank in 1961, effective nationalization of commercial banks in 1962, and establishment of special financial institutions (Park, 1994; Cho, 2002). The control was the essential government plan itself, and each 5-year plan stipulates how much funds should be mobilized and where to be invested extensively (EPB, 1962; EPB, 1967). Establishing the control, the government first endeavored to mobilize the financial resources to the utmost. Even the interest rate liberalization in 65, almost doubling the rates, which increased the domestic saving a lot, was another measure for the control since the banking sector was under the government control 15(Harris, 1988). Besides, it encouraged the nonblank financial institutions (NBFIs) and capital market since the 70s’ in an effort to attract capital from the curb market and address corporate debt problems (Lee, 1998). To promote investment, various policy loans with preferential interest rates were utilized in the allocation of capital. The government had the banking sector provide a huge policy loan, backed by the central bank, and set up special funds like and the National Investment Fund established in 1973, with most of it lent to the HCI sector. The bank-lending rate itself was much lower than the curb market, and the policy loan 16rate was with even lower rates, which helped to increase investment in priority sectors. The subsidy worked as a monitoring mechanism creating ‘contingent rent’ like in the 17case of the export loan. From 1961 to 1970 the ratio of policy loan to all loans was as high as above 65% in bank loans, and even from 1973 to 1991 the policy loans out of all deposit banks loan was around 61% (Choi, 1996). Its structure evolved in line with the 15 It was so successful that private savings and bank loans soared rapidly over the next four years, the growth rate of bank loans rose from 10.9% during 1963-64 to 61.5% during 1965-69 (Choi, 1996). But the general trend of the policy was ‘low interest rate’ and the government turned to low rate policy in the recession of the early 1970s. 16 In the 60s, the average curb market lending rate was more than 50%, while the general bank lending rate was about 25% and the export loan rate was mere 6%. In the 70s, the average curb market rate was about 40%, while the bank lending rate and export loan rate were around 18% and 8% and the NIF rate was 14%. Average inflation rate was around more than 15% for the period. (Cho, 2002). 17 Among various measures including pecuniary incentives like depreciation of the exchange rate, subsidy in tax, tariff etc., financial support was the most important. In 1967, the ratio between financial and fiscal subsidies to export was about 7:3 from 1965 to 1980 (Cho and Kim, 1997). The rent created in export loans increased from 0.3% of GNP in 1963 to 1.7% in 1970, 3.0% in 1975 and 4.7% in 1980 (Cho, 1997) industrial policy, with export loans the largest share, and others including loans for machinery, special equipment funds, and foreign currency loans mainly allocated to the HCI sector large up to the mid 1980s’ (Lee, 1998). Table 1. here. The system took another role to share the risk of the corporate sector investment, and the government actively managed it ex post, as well as encouraged it, establishing a distinctive coinsurance mechanism (Cho and Kim, 1997; Lim, 2001). It frequently intervened into the corporate restructuring process whenever the economy was faced with a crisis, based on financial control, though it’s later period. In 1972, the 8.3 measures announced a moratorium on the payment of all corporate debt to the curb market and extensive rescheduling of bank loans at a reduced interest rate to bail out the debt-ridden corporate sector. After the economic recession of 1979-80, the government again led corporate merger programs with financial measures like special loans, guarantee of payment and debt-equity swaps and even a moratorium on bank-loan repayment. Thus, the financial system played a role of mobilizing capital to utmost, allocating it into specific sectors, and managing the risk, to promote and manage 18investment (Cho and Kim, 1997). It maximized the benefit of the bank-based system of promoting long-term and stable investment, not possible left to the market (Zysman, 191983). In fact, the saving rate increased so much from around 10% of GDP in 1960 to 20% in late 1960s’ and 30% in late 1970s’, and investment increased even further. Naturally, the government needed to attract foreign capital to finance the gap, and it successfully managed it based on capital controls under the financial system. 18 Demetriades and Luntiel (2001) shows that the government regulation led to financial deepening in Korea from the perspective of recent financial restraints theory. 19 In comparison with the capital market-based system, it is argued that the bank-based system is better to encourage long-term and the close bank-business relationship is helpful to better monitoring like the Japanese main bank system (Allen, 2000; Aoki et al., 1994). In Korea, banks were repressed and controlled, and all process was managed by the state. IV. Capital Controls under the Developmental state in the 1960s 1. Active capital management policy in the 1960s Extensive capital controls over foreign capital flows were actively used, exactly incorporated into this state-controlled financial system (Nembhard, 1996). It is the 1960s that the strong capital controls system was built in place by the military government. As early as 1962, the government transferred the control over the foreign exchange from the central bank to the ministry of finance (MOF), and the Foreign Capital Inducement Act in 1961 legally stipulated the strong capital controls in a broad gamut from current account restrictions, foreign exchange and currency restrictions, foreign direct investment to foreign borrowing. The Capital controls in Korea were legally set up under the Foreign Capital Inducement Act in 1961, lied in a broad gamut including exchange and other controls. With several revisions of the act, the government made a great efforts to manage the foreign capital flows. First of all, the foreign trade, especially import was strongly controlled by the government, which naturally led to the control in current account. Foreign exchange transaction had also long been in strong control of the government from the 50s’ before the industrialization started, that residents could neither own foreign currency nor foreign securities. The strict exchange restrictions were applied to almost all capital outflows till the 1980s. Tight regulations on foreign investment and its enforcement were famous in Korea. Foreign direct investment inflow was regulated by a ‘positive list’ system up to 1984. The government inspected investment project very rigidly at first, and limited foreigners’ ownership of domestic industry. Mostly, only joint ventures between foreign and domestic capital were permitted and moreover it was compulsory for foreign investors to resell their share after some years. Also, the government didn’t allow foreign investment that might compete with domestic firms and attempted to gain the most benefits, inducing competition among foreign investors. Technology-related investment was encouraged but the government attached several conditions for transfer of technology. It established various mechanisms in order that foreign direct investment was a conduit of advanced technology and managerial expertise for domestic development, although limiting the foreign penetration. As a result, foreign direct investment had only a minor role in capital formation, compared to other developing countries (Mardon, 1990). The table 2 and 3 show its share in the total long-term foreign capital and total domestic investment was very low. Also, the residents’ direct investment abroad was also restricted to a great extent in the 60s’ and 70s’ and there was no outward investment by Korean firms at all till 1967. As far as foreign loan was concerned, it was not hindered but promoted and 20managed by the government itself. The government aimed at mobilizing it for 21industrialization to complement scarce domestic savings. For the purpose, again it utilized the state-controlled banks, letting them guarantee long-term foreign currency loans by the private sector. The government introduced new laws to allow for the payment guarantee by the government in 1962, and amended ‘Foreign Capital Inducement Act’ in 1966. With these laws and normalizing diplomatic relationship with Japan, the foreign loan began to increase. As the private business did not have credibility to borrow foreign capital directly, the nationalized banks played an essential role of guarantor. The government was also active to attract the foreign loan from diverse sources including multilateral lending and international financial markets (EPB, 1967). Due to these measures, the long-term loan soared since the mid-60s’ as in the table 2, 22in particular with the skyrocketing commercial loan. The ratio of payment guarantee on foreign borrowings to total deposit money bank loans increased from 11% in 1965 to 71% in 1967 and 94% in 1970 (Choi, 1996), and the foreign debt increased as in the table 3. The share of foreign saving in GDP between 1966 and 1982 was as high as 20 In the 50s’ the foreign aid from U.S. was very important source of investment, which was higher than domestic saving. In particular it accounted for around 30% of the government revenue and a crucial share for the fiscal investment and loan. The foreign aid flow was still high in the early 60s’ (61-65) with about $ 200 million, more than long-term loan. But the U.S. government started to cut the aid, and the government responded to it with efforts to attract foreign loan. 21 Foreign capital inflows consist of long term foreign capital including public loan, commercial loan, bank loan, bonds, and long-term trade credit, and short term capital including trade credit and refinance. Bank loan that started from 1968 changed more important since the late 70s’ but other inflows were of no consequence. We report data for long-term public and commercial loan that were most important for economic growth. 22 Interestingly, the commercial loan was 5 times bigger than the original plan in the second economic 5-year plan period. In the plan (1967-1971), the government attempted to regulate quality of commercial loan since that with bad conditions came in too much but went to failure to repress the strong demand (EPB, 1967). It caused the difficulty in the corporate sector in the early 70s. about 5.5%, only to finance high investment and huge trade deficit. Indeed, investment and economic growth banked highly on foreign long-term capital in the early period of development and without it, the growth rate must have been lower taking longer. But because foreign borrowing was possible only on approval of the ‘Foreign Capital Inducement Committee’ of the government, the government could control and allocate them to specific effectively. Controls over foreign capital with lower interest rate provided a great tool for the industrial policy (Cho and Kim, 1997). However, the dependence on long-term foreign loan aggravated the foreign debt problem seriously later in the early 80s, shown in table 3. In fact, Korea was the second-largest borrower 23after Brazil, and was one of the riskiest countries in 1980. Nevertheless, the government could overcome the 1980 crisis thanks to the friendly political support from U.S. and Japan (Woo, 1997). Finally, the huge trade surplus in the late 80s’ could resolve this problem. Table 2, 3. here, Figure 1. here 2. Successful controls for growth under the developmental state Capital controls played important roles in economic development in Korea, which was possible thanks to the specific institutional feature of the developmental state. First of all, the strong control over capital outflows were helpful to contain domestic capital and increase domestic investment. The bloody measures against capital flight in Korea were very well known and the government emphasized the utmost importance of available financial resources (Amsden, 1989). Secondly, it is very important that the government not only controlled the foreign capital flows but also endeavored to attract 24foreign capital mostly as a form of borrowing to finance domestic investment. At a 23 Euromoney ranked Korea’s country risk 35th out of 67 countries, far beind Mexico (21st) , Brazil (23rd) and Phillippines (24th). Euromoney, 1980. 24 The government effort to attract foreign capital in the 60s’ was well known. In fact as the international organization and U.S. government were skeptical about the ambitious industrialization plan, they had hard time. For example, the Park administration tried to make a long-term loan from the IBRD to build Pohang Steel Company but rejected, and the commercial loan through the private consortium of KISA(Korea International Steel Associates) also failed getting loan from American Export-Import bank. time, it successfully managed foreign capital after borrowing, allocating it into the priority sector under the state-led financial system. Lastly, the government used a specific mode of foreign finance. It tried not to rely on foreign investment with strong regulation, and thus the foreign dominance was limited in favor of rather independent national development. Surely, the institutional factors of developmental state as we mentioned, was essential. Many researchers argue that capital controls are related to politics like leftist power in government, weak central bank, and income distribution which has something to do with power relationship between classes (Epstein and Schor, 1992). In developing countries, the strong will and capacity of the government are more important. In Korea, in the beginning, since there were no strong interest groups like domestic who might want more liberal regime, it’s easier to adopt strong controls. In fact, the strong military regime could repress any trial of capital flight with the bloody control over the all features of the economy. Nobody could dare to be against the government when chaebols leaders were summoned after the military coup and accused of corruption. Also, the bureaucratic capacity with the strong development-oriented mind with relatively less corruption could achieve effective controls. In 1961, with the setup of Economic Planning Board (EPB) as a pilot agency, the special department for foreign capital attraction was established in it so that the controls can be incorporated into the economic planning. The autonomy of the state from the international capital and international geopolitics was crucial in the unique manner of mobilization of foreign 25saving. The government could sustain autonomy since the form of foreign capital was not direct investment but mostly multilateral long-term loan, mediated by the government itself. Thus, successful capital controls were thanks to the institutional structure of developmental state in many was. More important is how controls could spur economic development. Most of public loans like economic cooperation loan from Japan was spent for industrial development Finally they succeeded in it with foreign capital from Japan, with a different and more ambitious plan (Oh, 2003). 25 With the ‘Cold War’ the U.S. government was a bit permissive on Korea to adopt protective industrial policy and restrictive capital accounts since Korea was on the front against communism (Cummings, 1999). Thus, Woo concludes the Korean manner of mobilizing foreign savings was unique, in comparison with that of Japan (which did not rely on foreign savings) and Latin America (which relied on different sources of foreign savings). (Woo, 1997. p. 59.) like Posco and other infrastructure (Cho, 2001. pp. 10-13.). And the government emphasized the extensive examination of incoming foreign capital ex post management in the 5-year plans (EPB, 1962, 1967). The foreign currency loan from banks was an important source of the policy loan, and among others, the commercial loan of the private business, guaranteed by banks, was possible only with the government examination and permission. Thus, in Korea, capital controls worked within the state-led financial system to encourage productive private investment. It also enabled the government to discipline and support businesses further, thus contributed to the 26government-business relation. When private businesses always needed more capital, and control over attractive foreign capital provides the government with a strong tool to control them (Haggard and Cheng, 1987, pp 110-113.) Hence, the experience of Korea shows how the government can successfully control and manage foreign capital for 27development with strong financial control and proper industrial policy. The developmental state allowed for the specific manner to mobilize and allocate foreign saving in Korea. 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Table 1 : Share of Policy Loans by Deposit Money Banks and Special Banks (%) 1973-81 1982-86 1987-91 Average 73-91 DMB policy loans (A) Government funds 7.5 7.4 8.0 7.6 NIF 4.3 5.1 3.0 4.2 Foreign currency loans 21.1 19.7 19.4 20.3 Export loans 21.3 16.9 5.2 16.2 Commercial bill discounted 8.0 13.9 16.5 11.6 Special funds for SMCs 5.9 5.6 6.5 6.0 Loans for AFL 6.1 5.3 7.4 6.2 Housing loans 8.0 13.1 14.1 10.8 Others 17.7 13.1 20.0 17.1 Total 100.0 100.0 100.0 100.0 Loans by special banks (B) KDB loans 91.9 71.7 83.7 84.8 (NIF) (25.7) (18.5) (7.9) (19.5) EXIM loans 8.1 28.3 16.3 15.2 (NIF) (2.5) (4.7) (2.3) (3.0) Total 100.0 100.0 100.0 100.0 (A) / DMB loans 63.0 59.4 59.5 61.2 (B) / NBFI loans 48.0 32.3 15.3 35.9 (A) + (B) / domestic credit 48.9 40.8 30.9 42.4 Note : 1) The share of NIF (National Investment Fund, specially for HCI program) is annual average during 1974-81 2) Others include loans for imports of key raw materials, loans for machinery, equipment loans to the export industry, special equipment funds, and special long-term loans. Source : National Statistics Office, Korean Economic Indicators, various issues; Bank of Korea, Monthly Bulletin, various issues; in Cho and Kim(1997) Table 2. Long-term foreign loan and FDI in Korea FDI/ Public Commercial Total (total long Long-term Long-term long-term Foreign direct term loan + Year loan loan loan investment FDI) $ million % 1962 6.3 0.1 6.4 0.6 8.6 1963 24.3 18.9 43.2 2.1 4.6 1964 11.1 19.1 30.2 3.1 9.3 1965 11.2 27.9 39.1 10.7 21.5 1966 62.7 109.6 172.3 4.8 2.7 1967 79.7 137.7 217.4 12.6 5.5 1968 112.1 252.1 364.2 14.7 3.9 1969 148 360.8 508.8 6.9 1.3 1970 146.6 282.9 429.5 25.2 5.5 1971 324.5 319.5 644 36.7 5.4 1972 437.5 298.5 736 61.2 7.7 1973 403.5 460.6 864.1 158.4 15.5 1974 385.2 603 988.2 162.6 14.1 1975 476.8 801.5 1278.3 69.1 5.1 1976 712.9 838.9 1551.8 105.5 6.4 1977 637.9 1241.1 1879 102.2 5.2 1978 817.9 1913.2 2731.1 100.4 3.5 1979 1089.2 1578.4 2667.6 126.9 4.5 1980 1516.4 1402.3 2918.7 96.6 3.2 1981 1679.5 1257 2936.5 105.4 3.5 1982 1868 913.6 2781.6 100.5 3.5 1983 1493.4 973.4 2466.8 101.4 3.9 1984 1424.2 858.4 2282.6 170.7 7.0 1985 1023.7 964 1987.7 250.3 11.2 1986 880 1620 2500 477 16.0 1987 1109 1558 2667 1060 28.4 1988 891 988 1879 1283 40.6 1989 472 860 1332 1090 45.0 1990 418 30 448 803 64.2 Source: Economic Planning Board (EPB), Bank of Korea (BOK), Ministry of Finance and Economy (MOFE), arrival base Note: 1) Commercial loans are loans to the private sector, usually with the guarantee from the banks. Public loans are loans to the government institutions, and ones guaranteed by the government. The data are for only total inflows. 2) The share of foreign capital in investment in reality must be higher in the early 60s’ considering the big share of foreign aid in the government saving that was high. Table 2. Foreign debt, long-term loan and foreign direct investment in Korea Long-term FDI/ loan/ (FDI + long- Domestic Domestic term loan)/ Foreign Foreign debt Year investment investment GDP debt /GDP % % % $ million % 1962 0.2 2.4 0.3 89 3.9 1963 0.5 9.4 1.7 157 5.8 1964 0.8 7.9 1.1 177 6.1 1965 2.5 9.2 1.7 206 6.9 1966 0.7 23.5 4.9 392 10.1 1967 1.4 24.8 5.5 645 15.4 1968 1.1 28.1 7.3 1199 23.1 1969 0.4 28.1 7.9 1800 27.7 1970 1.3 21.6 5.7 2245 28.1 1971 1.6 27.3 7.2 2922 31.1 1972 2.7 32.6 7.5 3589 33.9 1973 4.6 25.1 7.6 4260 31.6 1974 2.7 16.4 6.1 5937 31.6 1975 1.1 21.0 6.4 8456 40.1 1976 1.4 20.0 5.7 10533 36.4 1977 1.0 17.6 5.3 12648 34.1 1978 0.6 16.0 5.4 14871 28.6 1979 0.6 11.9 4.5 20500 33.1 1980 0.5 14.6 4.8 27365 44.0 1981 0.5 14.1 4.4 32490 46.7 1982 0.5 12.9 3.9 37314 50.2 1983 0.4 10.2 3.1 40378 49.1 1984 0.6 8.2 2.7 43053 47.5 1985 0.9 7.0 2.4 46762 50.1 1986 1.5 7.9 2.8 44510 41.4 1987 2.6 6.5 2.8 35568 26.3 1988 2.3 3.3 1.7 31150 17.2 1989 1.5 1.8 1.1 29372 13.3 1990 0.8 0.5 0.5 31699 12.6 Source: Ibid. Figure 1. Investment and saving in Korea (1960-2002) Investment and saving in Korea 50 40 30 20 % of GDP10 0 -101960 1963-20year1966 1969 domestic savingdomestic investmentforeign saving1972 1975 1978 1981 1984Source: Bank of Korea (BOK). Note: Foreign saving is calculated by domestic investment minus domestic saving. 1987 However, in the 60s’ the share of government saving is more than 30% in the total 1990saving and the share of foreign capital like aid was very high. Thus, the share of foreign 1993saving must have been more important. The 5-year economic plan reports show the 1996share of foreign saving accounted for around 50% of total investment in this period based on division of the government budget (EPB, 1967). 1999 2002 Table 3. Change of external fund financing in the corporate sector in Korea (%) 1970 1975 1980 1985 1988 1990 1992 Indirect finance 39.7 27.7 36.0 56.2 27.4 40.9 36.3 Borrowing from banks(A) 30.2 19.1 20.8 35.4 19.4 16.8 15.1 Borrowing from NBFIs 9.5 8.6 15.2 20.8 8.0 24.1 21.1 Direct finance 15.1 26.1 22.9 30.3 59.5 45.2 41.4 Treasury bills 0.1 0.8 0.9 0.8 5.3 3.1 3.3 Commercial paper 0.0 1.6 5.0 0.4 6.1 4.0 7.6 Corporate bonds 1.1 1.1 6.1 16.1 7.5 23.0 12.5 Stocks 13.9 22.6 10.9 13.0 40.6 14.2 15.9 Foreign borrowings(B) 29.6 29.8 16.6 0.8 6.4 6.8 5.0 Others 15.6 16.4 24.5 12.7 6.7 7.1 17.3 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 (A) + (B) 54.8 48.9 37.3 36.2 25.8 23.6 20.1 Source : The Bank of Korea, Understanding of capital circulation in Korea Note : Others include government loan and corporate credit.