Korea ; Japan ; Banks and banking - Pacific Basin ; Pacific Area

Chan Huh

Sun Bae Kim

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 94-33, September 30, 1994
Measuring the Cost of "Financial
Repression"
Real GNP growth in South Korea (Korea, hereaf-
ter) averaged close to 9 percent a year over the
past 25 years. This rapid growth puzzles some
economists, however, because it was achieved
under a financial system that many would de-
scribe as "repressed." Until recently, interest rates
in Korea have been tightly regulated, and most
investable funds have been channeled through a
government-owned banking sector that extended
loans at below-market interest rates to govern-
ment-picked priority sectors.
Was financial repression indeed costless? This
Weekly Letter provides an indirect measure of the
cost offinancial repression by focusing on the bad
loan problem in the banking sector. As a bench-
mark for comparison, we use our estimates of the
bad loan problem in Japan (Weekly Letter 94-32).
Both Japan and Korea have relied extensively on
the banking sector to finance growth. Yet we find
that the bad loan problem has been more severe
in Korea than in Japan. We interpret this result as
reflecting the relatively lower discretion Korean
banks have had, in comparison to Japanese banks,
to allocate funds as well as their lower incentive to
control bankruptcy risks through screening and
monitoring corporate borrowers.
Overview of institutional differences
Japanese banks are relatively free of government
control; in addition, a large number of studies
now suggest that Japan's banking system, in par-
ticular the so-called main banking system, has
been highly effective in mitigating informational
and other imperfections in capital markets such
as those in the u.s. (see, for example, Kim 1993).
Although the main bank identified with a partic-
ular firm is not its sole lender, it is usually the
only bank that undertakes the task of monitoring.
Two additional features of the system suggest that
powerful incentives were present for the main
bank to be diligent in carrying out this task. First,
if a firm monitored by a given main bank gets
into financial distress, that main bank also is
expected to assume the bulk of the burden in
restructuring it or bailing it out. If bankruptcy oc-
curs, the main bank usually absorbs a proportion
of losses larger than its loan share. Second, the
main bank also faces positive incentives to mon-
itor actively due to the claims structure it holds:
The main bank typically is not only the largest
lender, it is also an important shareholder, usu-
ally the largest among the lending banks.
In Korea, as in Japan, banks have played a dom-
inant role in financing the country's economic
growth. This came about largely as a result of
conscious policy design. The Korean authorities
sought to use banks as a conduit of preferential
credit to sectors deemed strategic to growth. The
use of preferential access to credit at subsidized
interest rates (known as "policy loans") inten-
sified in the 1970s when the government made
a major push to establish a heavy and chemical
industries (HCI) sector. The HCI share of policy
loans in all banks' loans is estimated to be as
high as 65 percent, on average, in 1973-1981
The actual share of government-directed loans
would be even higher if one included loans that
were not extended through explicitly earmarked
programs.
Compared to Japan, the Korean government ap-
pears to have wielded tighter and much more
direct control over the banking sector. Most not-
ably, unlike Japan, the government until recently
has been the major shareholder in all major com-
mercial banks. Tight government control gave
rise to two types of moral hazard problems in
credit markets. On the supply side, banks had
little discretion or incentive to control risk by
screening projects and monitoring corporate
PACIFIC BASin nOTES Pacific Basin Notes appears on an occasional
basis. It is prepared under the auspices ofthe Center for Pacific Basin Monetary and Economic Studies
within the FRBSF's Economic Research Department.FRBSF
performance. Declaring any sizable industrial
enterprise bankrupt or writing off bad loans on
bank balance sheets required the explicit con-
sent of the government. In practice, the govern-
ment averted the bankruptcy of large enterprises
by directing banks to provide relief loans or to
reschedule debt. In turn, commercial banks re-
ceived compensating measures such as interest
payments on reserve deposits banks held at the
Bank of Korea and special loans at low interest
rates.
Extreme control and guidance of banking institu-
tions had adverse incentive effects on the demand
side of the loan market as well. The socialization
of bankruptcy risk, combined with the strict low
interest rate ceilings, made the cost of debt fi-
nancing very cheap for firms in the targeted
sectors. This encouraged firms to take on exces-
sively high levels ofdebt, which, in turn, made
them vulnerable to external shocks and eco-
nomic fluctuations. This excessive debt problem
took on especially alarming proportions by the
end of the 1970s, and the government responded
by becoming more involved in banks' credit allo-
cations to bailout troubled firms and industries.
As a consequence, banks were saddled with ever
growing amounts of de facto nonperforming
loans.
Measuring the bad loan ratio
According to a study that estimates the bad loan
problem (Chung 1991), as much as 25 percent of
outstanding loans fell into this category in 1988.
This estimate is based on a broad definition of
nonperforming loans, which includes loans to
companies whose credit conditions have deterio-
rated so markedly as to warrant explicit loan
principal recovery measures, along with loans
whose probability of repayment is virtually nil.
Obviously, this is quite large. Our worst case esti-
mate for japan in 1992 was about 10 percent in
comparison.
It would be interesting to obtain some consistent
measure of the bad loan estimate in Korea to see
whether the 1988 figure is an exception or not.
However, direct and precise measurement of bad
loans based on banks' various accounting state-
ments is not feasible. First, consistently measured
data are not available. Second, existing data are
likely to understate the scope of the problem,
since banks customarilycarry substantial amounts
of nonperforming loans on their books.
Thus, in estimating the bad loan ratio, we em-
ploy a method that uses loan demand data
obtainable from corporate balance sheets. The
same method was used in our earlier Weekly
Letter to estimate the bad loan problem in japan.
The severity of the bad loan problem was gauged
by looking at the default rate on notes payable in
the corporate sector. We adopted this method
because of institutional similarities between the
two countries. As in japan, firms in Korea rely
heavily on notes as a means to raise short-term
liquidity. The commercial paper market, for ex-
ample,has been instituted only recently and
typically handles longer-term paper. Notes are
frequently discounted by banks and default is
promptly reported. Note default is a good ba-
rometer of the financial health of the corporate
sector and, thus, the extent of the bad loan prob-
lem in Korea.
However, unlike japan, the data related to bank
transaction suspensions are not available in
Korea. Thus, we used just the note default
amount and the outstanding amount of notes
payable in each period. The bad loan ratio (BLR)
equals the note defaults divided by the outstand-
ing notes payable plus the note defaults. It is
important to note that this BLR is a measure of
the new bad loan problem that is expected in
each period.
Historical pattern of the estimated
bad loan ratio
Figure 1 shows the estimated bad loan ratio for
Korea during the past 20 years. Several episodes
are noteworthy. The first oil shock did not cause
much of a noticeable increase in the estimated
ratio. Indeed, Korea's economy continued to ex-
pand at about 8 percent throughout 1973 and
subsequent years. However, the bad loan prob-
lem appears to have been most severe in the
early 1980s. The ratio exceeds 7 percent at its
peak in 1981-1982, the period immediately fol-
lowing the drive to build up the HCI sector. This
surge in bad loans can be reconciled with sev-
eral adverse shocks to the Korean economy
around that time. Korea's GNP shrank by almost
5 percent as a result of the drought-induced re-
cession of 1980. Weak domestic economic con-
ditions were compounded by the world recession
after the second oil shock, pushing many highly
leveraged firms into insolvency.
The bad loan ratio trended downward in the sec-
ond half of the 1980s, though the decline was
punctuated by a minor surge in 1987. This surge
coincided with the well-known episode in 1987
when many construction companies went bank-
rupt as a result of cancellations of large overseasChung, Un Chan. 1991. Financial Market Reform (in
Korean). Seoul: Bupmun-sa.
Huh, Chan, and Sun Bae Kim. 1994. "How Bad Is the
Bad Loan Problem in Japan?" FRBSF Weekly Letter
94-32.
Kim, Sun Bae. 1993. "Why Do Japan's Main Banks
Hold Corporate Shares?" Mimeo. Federal Reserve
Bank of San Francisco.
Sun Bae Kim
Senior International Economist
Goldman, Sachs & Co.
Chan Huh
Economist
References
Conclusion
While the banking sector potentially can make
a significant contribution to economic growth,
financial intermediaries themselves need to face
an incentive structure that encourages them to
screen and monitor corporations diligently. The
Korean experience suggests that heavy govern-
ment intervention can seriously mute such incen-
tives, which resulted in exposing the banking
sector to unduly high risk compared with ex-
pected mean return. The higher bad loan ratio
may be but one manifestation ofthe associated
costs of "unduly" repressing the banking system.
Korea's case indeed shows that concentrating
financial resources can engender economic
growth, but at a substantial cost.
Are these high bad loan ratios indeed plausible?
One way to check is to compare our estimates
with the 1988 estimates of Chung's study. This af-
fords us at least a partial check for the benchmark
year of 1988. His estimate of 25 percent com-
pares to our estimate ofthe cumulative bad loan
ratio in 1988 of 17.9 percent using the 10 percent
write-off rate and 30.2 percent using the 5 per-
cent write-off rate. It wouId appear, therefore,
that for 1988 at least, the actual bad loan ratio
falls between the lower and upper bounds of our
cumulative estimate.
total outstanding loans were nonperforming as of
1992.Q4. Carrying out the same exercise using
the annual write-off rate of 10 percent yielded
27.1 percent in 1992.Q4. By either measure, the
bad loan problem in Korea appears quite signifi-
cant both in absolute terms and relative to Japan.
4.8
4
3.2
2.4
1.6
73 75 77 79 81 83 85 87 89 91
In light of these considerations, we also calcu-
lated the cumulative bad loan ratio under two
alternative scenarios. First, we derived an upper
bound estimate using an average annual write-off
rate of 5 percent; that is, we cumulated 95 per-
cent of new bad loans each year over the entire
sample period 1973-1992. According to this up-
per bound estimate, some 36.7 percent ofthe
6.4
Plausibility of the estimate
Our estimated series may significantly understate
the actual extent of the bad loan problem since,
under government directives, banks usually have
carried large amounts of nonperforming loans on
their books over long periods. It is widely be-
lieved that banks on average have been writing
off, in any given year, only about 5 percent of the
total bad loans; that is, 95 percent of bad loans
have been carried over from one year to the next.
Korean commercial banks still need to obtain
permission from their regulatory agency for any
substantive amount of write-off.
7.2
contracts. Some large shipping companies also
slipped into financial distress. Finally, Korea's bad
loan ratio increased sharply in 1990, reaching a
level comparable to that observed in the early
1980s. Part ofthe increase may be attributed to
the cyclical downturn in the Korean economy
in 1992.
8
Percent
Figure 1
Bad Loan Ratio Estimate for Korea
5.6
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DATE NUMBER TiTlE AUTHOR
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94-32
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Measuring the cost of "financial repression"

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Measuring the cost of "financial repression"

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