From October to December of last year, Korea went from being the world's eleventh largest economy to one surviving on overnight loans from the international money markets. Between November 19, when Korea decided to approach the International Monetary Fund for a rescue, and December 24, the won fell more than 50 percent against the U.S. dollar, the stock price index tumbled from 498 to 350, and the short-term market rate of interest shot up to 40 percent a year.
Although the IMF made a huge rescue package available on December 3, Korean banks suddenly found themselves cut off from the international financial markets. During the last week of December, Korea was on the verge of defaulting on its foreign debts, a fate averted only by a last-minute emergency loan by the IMF and several G-7 countries.
Although Korean banks have been able to roll over some of their short-term debts and market sentiment seems once again to be turning in Korea's favor, Korea faces a long struggle in normalizing its ties to the international financial markets.
BUILDUP TO THE CRISIS: INVESTMENT BOOM
From 1995 to the beginning of 1997, Korea's economic growth averaged almost 8 percent a year, peaking in 1996 at nearly 9 percent. The growth was fueled by exports and also by high investment by Korean firms. And though investment seemed exactly the right prescription for an economy coming out of a mild 1992-93 contraction, in the end it contributed heavily to Korea's financial and foreign exchange crisis.
From late 1992 to mid-1995, the appreciation of the Japanese yen sharply increased the export earnings of Japan's East Asian trade competitors, especially Korea, and spurred investment throughout the region. In the third quarter of 1995, the yen began its long slide against the dollar, slowing not only Korea's exports but its economy as a whole. Korean policymakers made no substantial adjustments in the won-dollar exchange rate, and the real effective (trade-adjusted) exchange rate appreciated for more than a year and then remained relatively stable until the financial crisis broke out.
The investment boom, however, continued as foreign capital surged into Korea with the easing of capital controls as part of a general financial opening. With domestic interest rates more than twice those in world financial markets, net foreign capital inflows during 1994-96 reached $52.3 billion, more than triple those …
