Financial repression is defined as the use by official institutions, either the legislative body, the central bank or the government, of policies aimed at increasing available credit to government at the expense of private sector. So, funds that would otherwise be destined to private borrowers are directed to the government, often at below market rates.
Through these low interest rates, government reduces its debt servicing costs and, when financial repression is combined with inflation existing debt denominated in domestic currency is eroded. Typical financial repression policies include: caps on interest rates, controls on cross border capital movements, increased reserve requirements, allocation of captive funds (such as social security and pension funds, domestic banks) to government financing and tighter relations between government and banks (i.e. public ownership of banks). The concept is frequently employed to describe the situations in the period after World War II and in the years since the financial crisis of 2008.
However, the term also applies to the South Korean economic panorama in the 60s and 70s. Financial repression tools constituted a key feature of President Park Chung-hee rule from 1961-79; although they were adopted for different reasons: the purpose of the government was not to reduce its debt but to direct available funds to target industries. These were essentially firms in sectors with exportable profile and growth prospects and infant industries’ firms.
Soon after Park Chung-hee took power, a set of circumstances, namely the dramatic reduction of aid remittances by the USA, shifted South Korea’s economic policy orientation from an import-substitution to an export-substitution strategy. The country was the first among the “gang of four” to bring exports to the center of economic concerns, ahead of Singapore, Taiwan and Hong Kong1. In short, the logic and the subsequent success of the shift are due to a number of factors: Korea lacked in natural resources but had an abundant labor force, education was increasing both in its spread and in quality, the USA were willing to provide trade advice and access to a broad market, and advanced industrial countries were going through a boom.
Government began promoting an “Export-Oriented Industrialization”, conducting the production factors towards exportable goods. These were effective as one can observe through the growth in exports to GNI ratio (see graph). It implemented 5 year indicative economic plans that explicitly presented the reforms to be undertaken and the industries to be promoted2. Because the government settled export targets accomplishment as the country’s mission, it needed to protect exporting industries so they could face international competition and benefit from learning-by-doing effects, hence the implementation of high subsidies to firms, tax exemptions, restraints on import and cheap funding for the required investments.
Focusing on the financial sector, under the highly centralized rule Park Chung-Hee installed, all banks were nationalized as government took control of all forms of credit distribution. For this reason, capital movements were restricted (government was the sole entity able to borrow money from abroad). This full control over commercial banks and other institutional credit suppliers allowed the government to manipulate interest rates. Additionally, Bank of Korea, the country’s central bank, was naturally under fiscal dominance and therefore government also influenced monetary policy.
Because government wanted not only to direct investment towards exporting firms but also to provide them with cheap loans; eventually, the banking sector turned into a “non-profit public agency”. Banks entered in a scheme of strong credit rationing: as they lent money at extremely low rates, the demand for funds was much larger than supply and, naturally, target industries businesses were prioritized. The consequent distortion in the financial market produced a huge informal, unorganized and unsecure parallel credit market , “the kerb market”, that at its peak in 1964/65, was equal in volume of lending to around 40% of total regular bank loans. The poorer population, attracted by the higher returns, opted to put their savings in these schemes and those in need of loans, but rejected by regular banks, were forced to pay nominal interests rates that reached as high as 60%.
Simultaneously, from 1960 until 1981, South Korea had, the highest inflation rate among Asian NICs: around 18,8% annual. The inflationary pressures arose from the economy’s overheating, resulting from the aggressive export promotion that forced businesses into overly ambitious investments. Furthermore, as mentioned, high inflation rate translate into negative real interest rates, which was verified for 11 years during the period of 1960–1981.
This financial market distortion left deep impressions in the country’s economy. Thanks to the state-controlled credit allocation, a large share of funds was allocated to increasingly bigger and more powerful corporations, the chaebol, that undermined free-market system due to the monopolies attributed over time. Furthermore, when government eventually started to liberalize the financial market in the early 80s, the challenge of dismantling the centralized credit market, the controlled capital movements and the fixed exchange rate policy proved to be too hard of challenge to cope with. To cut a long a story short, inconsistent and unbalanced deregulation (prompted by the hurry to get OCDE membership in 1996), culminated in a major currency and banking crisis that put an end to the so called “Korean miracle” and justified the IMF arrival in 1997 with a bail-out package.
1. “Gang of Four”, Jagdishi Bhagwati 1972
2. For example, in the first plan (1962-1966), “trade policy’s aim was to expand exports as much as possible by providing exporting firms with cheap loans, tax benefits, export compensation schemes and various administrative supports”, on the second plan “major reforms included a financial reform, an exchange rate reform and a trade reform allowing imports of parts and machinery used in the production of exports goods”
The rise of the Korean Economy, Byung-Nak Song
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