INTRODUCTION

Although not the immediate trigger of Korea's financial and currency crisis in November 1997, poorly implemented financial liberalization contributed to the scale and pace of the crisis by weakening the financial structure of both the financial and nonfinancial corporate sectors during the preceding years. There were errors in sequencing of market and price liberalization as well as inadequate prudential regulation and supervision. The downturn was characterized, not by the bursting of an asset-price bubble, as was the case in many other countries, but instead by widespread insolvency among manufacturing firms, in particular the large chaebols.

The immediate cause of the crisis was the run of foreign creditors. This in turn was critical because of the level of short-term foreign debt which had risen to a multiple of usable foreign exchange reserves. The Thai crisis from mid-1997 contributed to the doubts of foreign creditors, but what really triggered their refusal to rollover loans to Korean banks was the rapid increase in the banks' nonperforming assets, with six of the thirty largest Korean conglomerates (chaebols) failing after January 1997. The fundamental reasons for this string of chaebol bankruptcies lay in the distorted incentive structure of the economy, which encouraged overexpansion of corporate investment and was reflected in excessive real wages, an overvalued exchange rate and other misaligned relative prices (Cho 1998a).

But there was also a contribution from the uneven, poorly phased approach to financial liberalization. Korea had launched its policy of financial liberalization in the early 1990s by implementing a four-stage interest rate liberalization plan and encouraging competition among the financial institutions. However, the actual implementation of financial liberalization deviated from what had been formally announced.