Foreign firms trying to enter the Korean market before the crisis of 1997 faced several obstacles. Extensive government intervention created policies that promoted and protected domestic industries. These policies also drew the "chaebols," the intricately and closely linked industrial conglomerates, into powerful partnerships with the government. And a paternalistic employment system, embedded with complex social norms, helped entrench Korea's unique business structure and management system. But though the structure was a strong one, it could not prevent the sudden economic crippling caused by the 1997 financial crisis. Fortunately, perhaps, the crippling was also a small blessing, unmistakably signaling that both the structure and the principles that supported the economy could not be sustained. The consequences for the Korean business community were huge, as dramatic policy shifts forced fundamental changes not only in how business was conducted but also in who conducted it. Today, the changes continue to have a considerable impact on foreign interests seeking to enter, or expand in, the Korean market.
The Business Environment: 1997 At the Korean government's request, the International Monetary Fund agreed to provide $58 billion in financial assistance to save Korea from defaulting on its foreign debt. The IMF imposed strict conditions and policies that are still forcing changes in Korea's business environment (all currency in U.S. dollars unless otherwise noted).
The causes of the 1997 financial crisis have been extensively researched and documented. They are primarily: (1) a loss of international competitiveness; (2) the chaebols' excessive expansion and diversification using debt capital; (3) an inefficient financial sector, with lax moral standards; (4) a lack of transparency in business and banking operations; and (5) an inflexible labour market. Each of these causes had its roots in the distinctive Korean business environment.
Korean companies' loss of international competitiveness was largely the result of the state's protection of domestic industries. Numerous government regulations distorted resource allocation and encouraged inefficient business operations. The government pursued its export promotion and industrialization policy through a limited number of chaebols, by providing the latter with financial assistance and institutionalized privileges, and protecting them from international competitors and minority shareholders. Such policies generated an excessive concentration of economic power in the hands of a limited number of chaebols, and a collusive government-chaebol relationship. Because of their perceived infallibility the chaebols relied mainly on debt capital from the domestic financial sector to expand and diversify. This was a direct cause of the financial crisis.
However, the crisis was caused by more than the chaebols' excesses. For example, in order to control credit to execute its industrial policy, the government also controlled and protected financial institutions as both owner and regulator. Collusion between the government and the financial sector became common. At the same time, the financial sector's efficiency declined and the perception that bank failure was unlikely grew even stronger. This led to an undercapitalization in the financial sector. Under pressure from advanced countries, Korea liberalized the sector in the early 1990s.
Almost immediately, banks borrowed excessively from the short-term, international capital markets and lent the money to chaebols for long-term projects. This policy was also a direct cause of the financial crisis. Collusion with the government and protection from any reform resulted in a lack of transparency in how the chaebols and banks were managed.
Finally Korean labour was inflexible. This was more than just a cause of the financial crisis. It was also a strong feature of Korea's distinct business environment. Labour's failure to respond to changing domestic conditions helped raise labour costs rapidly and discouraged foreign investment. Both outcomes also helped reduce Korea's international competitiveness. This brief analysis shows that the causes of the financial crisis were the very features that made Korea's business environment so distinctive and difficult for foreigners. Hence, the IMF's remedial measures required some fundamental shifts in what had become the defining features of Korea's business environment.
