SOUTH KOREA: FINANCIAL SECTOR LIBERALIZATION

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T00287R001001110002-8
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 12
• Document Creation Date: December 22, 2016
• Document Release Date: August 19, 2010
• Sequence Number: 2
• Publication Date: December 27, 1984
• Content Type: MEMO

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Central Intelligence Agency
DIRECTORATE OF INTELLIGENCE
27 December 1984
South Korea: Financial Sector Liberalization
Summary
South Korea's liberalization of its financial
sector is part of a broader effort to open its economy
that includes easing regulation of imports and direct
foreign investment. Economic policymakers are taking
deliberate steps to attract additional capital,
technology, and management skills, allow the market to
determine interest rates, and expand the use of equity
markets. Seoul recognizes that it must use caution to
avoid shocking the private sector as banks and
businesses are weaned from government-directed,
subsidized credit. Even so, foreign bankers in
particular will find increased opportunities to
provide financial services in trade and foreign
exchange transactions. We believe that the domestic
economy will be strengthened by a more efficient
mobilization of capital, more equitable allocation of
credit between large conglomerates and small firms 25X1
and a shrinking of the illegal curb m
rs
a
et
'See Appendix for an explanation of the curb market.
This memorandum was prepared by Korea Branch,
Northeast Asia Division,, Office of East Asian Analysis. Comments
and.queries are welcome and may be addressed to Chief, Korea
Branch r., c,. -- -- _ _ _
EA N 84-in2ln
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Seoul, which has been loosening controls on the financial
sector since 1982, has accelerated the pace of change in the last
year. This activity reflects, we believe, a growing concern with
scandals linked to the illegal curb market, renewed pressure from
foreign bankers, and protectionist measures being applied abroad
against South Korean exports produced with subsidized credit.
Liberalization efforts vary from one financial market to
another as do the prospects for future deregulation, but Seoul
has crafted its program to benefit all sectors by:
Promoting competition in the financial system.
-- Reducing government intervention in the routine
management of financial institutions, particularly
commercial banks.
Inducing foreign investment in Korean financial
institutions by easing restrictions on joint-ventures
and according foreign and domestic banks equal
treatment.
Developing new savings and debt instruments to improve
bank liquidity and end corporate dependence on
subsidized bank loans.
Controls on Commercial Banks Loosened
Seoul is gradually reducing the Bank of Korea (BOK) direct
control over the day-to-day management of the banking sector,
relying intead on general guidelines and standards of
performance. Under the aegis of the Ministry'of Finance (MOF):
In early 1983, the BOK, the central banking authority
and formerly the majority stockholder in South Korea's
commercial banks, completed a nine year divestiture
program.
25X1
The government has replaced direct credit controls for 25X1
each bank with indirect measures modelled after those
of developed countries, including reserve requirements,
rediscount operations, and open market operations.
-- The BOK's Office of Bank Supervision and Examination is
now concentrating on monitoring the financial
performance of individual-banks and has stopped its
micromanagement of bank personnel, organization, and
budgeting.
The government is phasing out its special financial
treatment of specific industries by eliminating
preferential interest rates and forced lending.(that
is, loans dictated by government policy).
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The Financial System in Korea
Commercial
Banks
-The Bank of Korea
C 'omestic Banks (17)
Foreign bank branches (4 9 )
Deposit
Money Banks
Non-Monetaryl
Financial
Institutions
Special Banks
Development
Institutions
Savings
Institutions
Life Insuranc
Companies
Secuntics
Market
5 Investment
1 Companies (4 1 )
rK-orea Stock Exchange
~--securities companies (2 5 )
Note: Figures inoarenthcses denote the number of institutions.
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Government influence over the financial system remains
extensive. The Ministry of Finance, for example, controls
interest rates in order to affect inflation and to avert the
slower economic growth that might result from higher, market
determined interest rates. A major result of this is a continual
credit shortage caused by low deposit rates that discourage
savings and a strong demand for loans spurred by below market
interest rates. In this situation, the absence of market forces
requires MOF to control the allocation of credit among sectors:
domestic banks must reserve a specified percentage of their
loanable funds for small- and medium-sized firms and other high-
risk borrowers -- groups bankers would otherwise shun in favor of
the largest firms. Foreign banks are not now subject to this
requirement but beginning in 1985 foreign banks will also be
required to hold similar reserves.
Seoul also continues to monitor credit flows to the largest
firms and to restrict them if they absorb too large a percentage
of total credit. MOF took such action against Korea's five
largest firms in late. 1984. Furthermore, Seoul has decreed that
no more than 10 percent of the voting shares in a single bank can
be held by individual investors in order to prevent the largest
conglomerates from controlling domestic banks.
We believe these regulations are necessary as a result of
the lack of market determined interest rates, the dominance of a
few large conglomerates, and the reliance of South Korean firms
on cheap debt -- a dependency encouraged by Seoul for almost
20 years to foster industrialization. The MOF's regulatory role
also recognizes that the banks and government agencies still do
not have experienced personnel who can manage loan portfolios
without BOK direction or the trained regulators to conduct
Interest Rate Decontrol
The government has taken a few cautious steps to loosen its
control over interest rates -- the key to a market-led financial
system -- but we believe prospects for a comprehensive decontrol
of interest rates soon dim. Prior to 1984, MO.F maintained a
rigid schedule of loan and deposit interest rates which is now
making way for a more flexible system that allows rates to vary
within MOF imposed limits. Bankers are now allowed to charge
loan rates that reflect the demand for credit and the riskiness
of the borrower, although at present even the most creditworthy
firms usually pay the highest limit on loan rates because of
scarce credit. The complete decontrol in November 1984 of.
interest rates in the call money market, the rate banks charge
other banks for loans, and in the unguaranteed bond market
underscore Seoul's commitment to financial sector
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Proponents of interest rate liberalization -- located
primarily in the Economic Planning Board (EPB) and MOF -- have
favored higher market-set rates to attract funds to domestic
banks, to maintain the tight money policy considered essential to
price control, and to encourage fiscal responsibility in
corporate borrowers and bank lenders. Critics of the revisions
have cited increased interest costs to business, a potential
slowdown in the economy, and a blunting of South Korea's
competitive advantage in export markets as disincentives that
outweigh the advantages of these reforms.
Monetary authorities at the MOF have generally preferred to
open new types of financial institutions and to introduce new
financial instruments that pay higher interest rates rather than
to adjust the rates on existing products. In the early 1970s,
for instance, they created several n,onmonetary financial
institutions such as short-term finance companies and mutual
savings banks that were allowed to offer higher interest rates.
That move was designed to attract curb market resources
(Appendix 1) and the new firms were the first authorized to offer
such innovations as commercial and industrial paper. Commercial
banks can now offer these products, as well as new high-yielding
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certificates of
deposit (CDs).
Despite the progress made, Seoul has not been responsive to
rapidly changing interest rate mark-et, signals and continues to
set rates in the largest credit markets. Moreover, interest
rates for savers, particularly small account holders, are
substantially below market levels. As a consequence, the curb
market still is more efficient at mobilizing savings than the
organized money market. Even so, we believe the freeing of
interest rates in important financial markets may accelerate if
the experimental call money market and unguaranteed bond rates
are not unusually high or volatile.
Foreign Bank Rules Eased
We believe that new regulations placing foreign banks on
near-equal footing with domestic banks in the competition for
won-denominated deposits and lending to domestic firms will help
alleviate criticism from overseas bankers. Nonetheless, a
variety of constraints on their role remain in effect, and
foreign banks argue that only equal treatment can encourage them
to provide new technology and management expertise, as well as to
offer the enhanced competition that promotes more efficient
banking operations in South Korea. Major areas of foreign
bankers' concern have been addressed by changes that put foreign
banks on the same footing as domestic banks in the public-bond
market and allow them to enjoy domestic bank status through
joint-ventures with Korean partners. In 1985, the government
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also will give foreign banks access to the BOK rediscount window
for preexport financing, followed bye provision of full privileges
on par with domestic banks by 1986.
Foreign bankers cite the lack of access to the rediscount
window as a key constraint on their effort to expand business to
domestic firms. Although their access to the rediscount window
will open new business opportunities --essentially by relieving
their chronic shortage of won -- it will aAso require them to
phase out the the use of swap transactions as the primary source
of won funds for foreign banks. Swap transactions currently
protect forei^n banks from foreign exchange risks and guarantee
profits on funds from home offices -- advantages not available to
Seoul ha.s not yet addressed the contentious issues of
foreign bank capitalization and property ownership. Foreign
bankers cannot make large, single-borrower loans, open new
branches, and provide high-profit, nonlending services on an
equal basis with domestic banks. because of regulations that
narrowly define their capital -- the basis for their lending
limits. Moreover, the prohibition against foreign banks holding
title to real estate and other property, including ships and
aircraft, denies their use of such collateral to secure loans.
Although Seoul's attention to several major problem areas
will make the investment climate even more attractive to foreign
bankers over the next few years, new areas of friction are
certain to arise as the financial community's activity expands.
Foreign bankers, for example, must still gain MOF approval to
enter newly opened,.markets, a process that is often lengthy
beca se regulations are not clearly spelled out. Moreover,
continued depressed profits among domestic banks may prompt Seoul
to close the door to new foreign banks.
2Loans to South Korean firms are typically made by discounting
commercial bills or promissory notes. The bank gives a business
firm a loan equal to the face value of the bill or note less an
interest charge. The bank then presents this bill or note to the
BOK which rediscounts a portion of its face value at an interest
rate that is currently 5 percent. The rediscounted note or bill
is a low interest loan to the bank which then can. make a new loan
with the proceeds at the official loan rate.
3Swap transactions occur when foreign banks acquire currency from
their home office (usually in the form of a,short-term loan) that
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? A
N
Equity Market Restrictions Relaxed
Seoul. has 'drafted a. comprehensive development plan for the
securities market to strengthen the Korea Stock Exchange
(KSE) . Government officials hope that a sophisticated
securities market will provide alternative corporate financing to 25X1
spur growth and attract foreign equity investment, thus reducing
foreign debt. Heretofore, the traditional reliance on
subsidized, government-directed loans that are less expensive
than equity or bond financing has retarded the development of
securities markets. 25X1
Seoul has opened the KSE to foreign investment in several
measured steps. Two $15 million trust funds of KSE-listed stocks
were privately placed with foreign institutional investors in
1981. The Korea Fund, started in 1984 as foreigners' first
chance to participate in the Korean securities market, has been
well received. Plans are being discussed for a second fund. A
limited number of foreign investors will be allowed to purchase
shares directly in prescribed industries in 1986. Restrictions
on repatriation of profits and on areas where foreign investment
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Seoul has encouraged the internationalization of the
securities market by allowing, on a reciprocal basis, foreign
securities dealers to open representative offices and, since
1983, ~o establish joint ventures with South Korean securities
firms. Korean securities firms overseas, which are strictly
controlled by the MOF, can only underwrite bonds of Korean firms, 25X1
but Seoul plans to lift restrictions on their bond market
activities in 1988. Koreans will be free to make investments in
foreign securities by the mid-1990s, when liberalization is
scheduled to be completed. 25X1
The success of the Korea Fund coupled with the excellent
growth prospects for firms listed on the KSE augur well for
continued foreign interest in Korean securities. As these
markets become more international, the process will provide more
capital to spur the domestic growth of South Korean firms and
enable them to tap global resources for debt and equity
financing.
The market value of.stocks listed on the KSE in 1983 was
$4.5 billion compared with $450 billion and $60 billion for
Japanese and Australian stock exchanges, respectively.
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5Representative offices are authorized to provide only market
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Outlook
Financial sector liberalization will be slow and steady as
Seoul attempts to nurture its nascent domestic financial
institutions and seeks.to attract foreign capital and technology
to this sector. We believe, however, that the long-term
prospects for movement toward an international; market-based
financial system are favorable. The key argument of the
liberalizers -- namely that greater reliance on market forces 25X1
will benefit. the Korean economy -- is gaining wider acceptance
within the bureaucracy. The current Chun cabinet, for example,
is heavily weighted with proponents of liberalization who have
eased restrictions on direct foreign investment and imports in
addition to opening the financial sector. Nonetheless, the
process is certain to move in fits and starts because of
bureaucratic tension. Political considerations, economic
conditions, and trading partner insistence on reforms ld also
alter the pace of the liberalization process. 25X1
- The pace of financial sector liberalization could
slacken if policy disputes exacerbate rifts within the
ranks of the liberalizers. In January 1984, a proposal
by Finance Minister Kim Mahn-je to align interest rates
with the market was opposed by Deputy Prime Minister
and EPB head Sin Pyong-hyon, delaying reform until 25X1
November. We believe that the liberalizers will
.continue to have Chun's ear, but greater caution and
his belief that liberalization and the economy are
progressing may well curb its pace.
Progress on the reforms also will depend on attitudes
among businessmen, politicians, and the general public.
Greater reliance on market forces carries a variety of
risks and uncertainties, and if economic conditions 25X1
deteriorate, criticism of government policy would put
heavy pressure on Seoul to retake control of the
-- The 1984 US Trade and Tariff Act is an important
impetus for accelerated financial sector liberalization
'in South Korea. Generalized System of Preferences
(GSP) benefits'are linked to progress in economic
liberalization and South Korean exports to the United
States could be sharply curtailed if these benefits
were withdrawn. The South Koreans are certain to 25X1
monitor carefully the US approach =:o implementaion of
the trade act's provisions. Meanwhile, Seoul will
probably argue for continued access to US markets by
highlighting its "developing country" status as well as
its unique defense and security needs that demand a
prudent economic ref program to maintain
stability.
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APPENDIX: The Illegal Money Market in South Korea
The curb money market, which operates outside the formal
.financial sector, provides an estimated 10 percent of total
domestic credit. Though not illegal in itself, nearly all curb
market transactions violate tax laws and are made by unlicensed
brokers. The existence of the curb 'market is explained, in part, 25X1
by a lack of diversified financial instruments for savers and
borrowers and by a rigid system of interest rates that are a
constraint in a dynamic economy such as that of South Korea. 25X1
The curb market is a relatively simple system (fi
ure 2) i
g
n
which a broker collects savings from households for loans to a
third party,.-usually a business firm looking for short-term
credit or, perhaps, to finance a wedding or holiday gift. Savers
receive higher than official interest rates with no tax liability 25X1
and borrowers are willing to pay high loan rates for scarce
capital. The official financial sector participates in the curb
market as bankers funnel funds between curb market brokers and
borrowers. 25X1
South Korea's curb market is periodically rocked by scandals
that paralyze this important source of short-term financing for
primarily small.- and medium-sized industries. The illegal and
unregulated nature of the curb market requires a high reliance on
trust in the broker by savers and borrowers. A 1982 scandal
resulted from a loss of. confidence in a major curb market broker 25X1
who blatantly displayed government connections, whereas a 1983
scandal was caused by the bankruptcy of a major curb market
borrower. These scandals have had only temporary effects on the
curb market which`rebounds with renewed vigor once order is
restored. 25X1
The government has, tolerated the curb market because it
helps to ease the-liquidity problems caused by its tight money
policies, but major scandals are prompting a harder line. The 25X1
recent liberalization of interest rates and laws discouraging. the
use of aliases which cloak curb market participants are moves
intended to dry up these resources and bolster the formal
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Flow of Funds in the South Korea
BORROWER
1, Z
COMPENSATING BALANCE*
INTEREST PAYMENTS
LOAN PAYMENTS
LOANS AND DEPOSITS
* Compensating balances are loan funds left on deposit at a
financial institution that raise the cost of borrowing by forcing a firm
to borrow more than is necessary to simultaneously meet financing needs
and the comaensatina balance.
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Curb ka j cket
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SUBJECT: Prospects for South Korean Defense Spending
Distribution:
1 - Mr. Tony Albrecht, State
1 - Ms. Harriet Isom, State
1 - Mr. John Hoog, State
1 - Mr. William Sherman, State
1 - Mr. Richard Childress, NSC
1 - Mr. William Martin, NSC
1 - Mr. Jay Taylor, State/INR/EAP
1 - Mr. Wallace Knowles, Pentagon
1 - Mr. James Kelly, Pentagon
? 1 - Mr. Doug Mulholland, Treasury
1 - Mr. William McFadden, Treasury
1 - Mr. Byron Jackson, Commerce
1 - Mr. Scott Goddin, Commerce
1 - Ms. Doral Coo er, USTR
1 - Mr. C/DO
1 - NI0/EA (7E-62)
1 - NIC/Analysis Group
1 - OEA/NEA/Korea Branch
1 - OEA/NEA/Japan Branch
1 - OEA/NEA Division
1 - OEA/China Division"
1 - OEA/Southeast Asia Division
1 - D/OEA (4F-18)
1 - C/Research/OEA
1 - FBIS/Analysis Group
1 - DDI (7E-44)
1 - Executive Director (7E-12)-
1 - PDB Staff. (7F-30)
5 - CPAS/IMC/CG (7G-07)
1 - CPAS/ILS (7G-50)
1 - C/PES (7F-24)
2 - OCR/ISG -
1 - DDO/EA/
1 -
4 - Author
DDI/0EA/NEA,
27 December 1984
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