KOREAN

FINANCIAL

REVIEW

Quarterly Analysis & Forecast

Vol. 7, No. 1                                                  Spring 1997

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

CONTENTS 

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

Lead Article: Korean Banks' Optimal Loan Ratio 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜

President and Publisher    Macroeconomic Developments 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜

Yung Chul Park 

Current Status and Prospects

Money and Interest Rates

Financial Market Developments 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜

Banking 

Non- Bank Financial Institutions 

Money and Capital Markets

Insurance 

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏 

Korean Financial Review: Quarterly Analysis & Forecast is published by the Financial Outlook Team of the Korea Institute of Finance (KIF). The views expressed are those of the authors, and do not necessarily reflect official positions of the KIF.

For subscriptions, please direct requests and inquiries to the Financial Outlook Team, Korea Institute of Finance, Seoul, Korea; Telephone, (82- 2) 3705- 6256, Fax, (82- 2) 3705- 6309. 

Korean Banks’ Optimal Loan Ratio

Donghyun Ji

I. Introduction

The banking industry learned a great deal about asset management from the Hanbo scandal in 1997. Perhaps, most importantly of all, the collapse of the Hanbo Group highlighted the importance of responsibility in asset management. It may seem very basic, but it is nevertheless all too often forgotten. Much improvement is required with regard to corporate governance and market discipline and other areas if Korean banks are to manage their assets in a responsible way. Should they fail to do so, they will find themselves creaking under the weight of enormous volumes of bad debt and become increasingly unsound, thus posing a serious threat not only to themselves and the financial sector, but to the entire economy. This paper raises two questions: Has the Korean banking system been made immune from the reoccurrence of financial debacles such as the Hanbo scandal? If not, how will Korean banks handle such bad loan problems?

The possibility of another Hanbo type sandal will always be there unless economic decision making can be divorced from politics in the loan market. Korean banks therefore need to find an appropriate way to prevent defaults on large loans. This paper suggests that Korean banks reduce their ratios of outstanding loans to total assets as one means of properly managing credit risk. 

Loan operations are of benefit only when banks are effective in gathering and analyzing information on and monitoring the borrowers. When banks fail to do so, they will incur losses in their loan operations. The sad truth today is that most Korean banks do not take these activities very seriously, so it should come as no surprise that so many of them are carrying such huge burdens of bad loans. 

This paper seeks to determine the optimal ratio of loans to total assets at Korean 

banks. It starts with the question of whether some Korean banks holding bad loans should maintain their current loan/asset ratios. If banks are incurring losses in their loan operations rather than realizing profits, they would do better to engage themselves more heavily in other financial services and make fewer loans. This may seem an obvious point, but one which should be made nevertheless seeing as so many banks have demonstrated a penchant for making risky loans under political pressure.

This paper attempts to determine optimal ratio of loans for banks by taking a systematic approach which may help Korean banks manage their credit risks. Compared with foreign banks, Korean banks have stronger incentives to expand their loan operations since they promote other financial activities such as deposits. To curb this incentive, the Office of Bank Supervision requires that commercial banks maintain their loan to deposit ratios at below 100 percent.

Most commercial bank managers in Korea believe that the real yield on loans exceeds the yield on risk- free assets. However, that is not the case if the loan loss rate is included in calculating the yield on bank loans. We are unfortunately not yet in a position to support this conjecture as we do not have access to loan loss data, but the importance of this data can hardly be understated. Korean banks need it so that they can calculate the real yield on their loans properly.

Korean banks tend to consider the size of loans important in loan management, and this of course encourages the expansion of the total volume of loans to levels at which the credit risks are inordinate. Because of this kind of recklessness in loan management, the leading banks in Korea tend to be overtaken by other banks about every three to five years.

Maintaining a proper loan to asset ratio, in addition to credit risk management, is also necessary for better management of liquidity and profitability. Across- the- board interest rate deregulation is now fully underway. Although this is of course central to the effort to deregulate the financial sector, it has become difficult for banks to charge interest rates which are sufficiently above the yield on risk- free assets. This situation is expected to continue at least for several years, and as a result banks would rather invest in risk- free assets than in loans.

Let us now discuss the criteria for determining the proper volume of loans at 

Korean banks. There has not been a great deal of research in this area, mainly because there is a negative spread between loan yields and the yields on risk- free assets, which is not a universal phenomenon but a local one. Data restrictions prevent me from engaging in quantitative analysis. Much of the discussion at the present time will necessarily be qualitative until data on loan yields finally become available.

This paper is organized as follows. Section II discusses some criteria for determining the proper volume of loans at Korean banks, especially with respect to other assets. Section III discusses the implication of the ratio of total loans to GDP and M₂. Concluding remarks are in section IV.

II. The Optimal Loan to Asset Ratio at Korean Banks 

1. Overview

There are both external and internal factors according to which banks determine the volume of loans and the ratio of loans to assets. The external factors include monetary policy, regulation, and the demand for loans, and the internal factors include the bank management's risk preferences and the bank's capacity to fund and manage risks such as credit and liquidity risks.

Moore (1994) suggested that the availability of capital and internal funds, and the economic situation were determinants of loan assets, and Lee (1996) suggested that the interest rates on loans, the volume of bad loans, and the terms and conditions to borrowers explain the volume of loans. Keeton (1993) pointed out that the channeling effect of bank loans from the money supply is becoming less and less important. He argued that the loan supply curve becomes elastic as the volume of loans becomes less dependent on the volume of deposits. Morris and Sellon (1995) stated that the relationship between bank loans and monetary policy has been weakening in recent years. They argue that there is little evidence of a credit crunch due to tight monetary policy. Furlong (1992) showed that the capital ratio has a strong correlation to the loan growth rate. 

A comparison of characteristics of bank loans with those of non- bank loans may provide some insights. The argument that bank loans are special is based on the 

observation that changes in the volume of bank loans due to shifts in monetary policy affect the consumption spending of borrowers. However, the decreasing market share of bank loans in the total loan market makes this argument less persuasive.

The availability of credit at the individual bank depends on its funding capacity and the management's preference for making loans over the holding of other income earning assets. The funding capacity depends on the volume of deposits, borrowed money, and capital. Korean banks face a great deal of regulation in issuing new shares and in borrowing money, so the main determinant is clearly capacity to raise deposits. In this case, a market share depends mainly on two factors: the number of branches and asset management.

The differences in the loan/asset ratios among individual banks reflect the differences in the factors indicated above. The loan/asset ratio can be measured in many ways such as loans to total assets or loans to total deposits. In this paper, the loan/asset ratio is measured as loans to total deposits, following the definition of the Office of Bank Supervision.

In 1995, the average loan to deposit ratio (hereinafter referred to as the LDR) at domestic commercial banks in Korea was 74.5 percent. The average LDR at nationwide city banks was higher than that at regional banks. This is consistent with the general observation that the LDRs of big banks are higher than those of small banks. However, newly established small city banks showed higher LDRs than larger and older city banks. It would seem that small city banks maintain higher LDRs in order to grow quickly.

Hana Bank and Boram Bank were both established in 1989, and their LDRs consistently rose over the period of 1993 to 1995. However, during the same period, the realized yield on loans at these two banks was lower than the risk- free rate. 

This may indicate that these banks sought to grow quickly at the cost of lower profitability.

For the 1990 to 1995 period, I computed the realized yield on loans as loan interest revenue divided by the average loan balance for the five largest city banks. Each year, without exception, the yields were lower than the risk- free rate. This is most interesting, especially as the yield on loans at foreign banks in Korea is higher than the risk- free rate. There are three reasons for this negative spread between loans and risk- free assets at Korean banks. The first is the significant volume of policy loans in the total loans. The interest rates on these policy loans are much lower than the market interest rate, so higher percentages of policy loans to total loans result in lower loan yields. The second is the low level of the contractual loan interest rate. Even though interest rate deregulation has been proceeding steadily since 1991, Korean banks are not yet completely free to set their loan interest rates independently. It is therefore not at all unusual for the contractual loan interest rate itself to be set below the risk- free rate. The third is the high loan loss rates which make the realized yield lower than the promised yield. In the case of one big city bank, for example, the average of the promised loan interest rates as of April 1997 was around 11.8 percent, but the yield on guaranteed corporate bonds was around 12.5 percent. The promised loan interest rate was therefore actually about 0.7 percentage points below the risk- free rate. Only if that particular bank could earn additional revenue in excess of the 0.7 percentage point difference in the form of compensating balances or fees could the ex ante yield on loans exceed the risk- free rate. However, I have not yet taken into consideration the loan loss rate. When the loan loss rate is included, the real ex post loan yield could be below the risk- free rate.

The regulatory guidelines on the LDR set forth by the Office of Bank Supervision stipulate that the ratio must be below 100 percent. Thus, there is a cap 

on the LDR for the Korean banks, but there does not exist a floor on it. The fact that the average LDR at domestic commercial banks in Korea is 74.9 percent implies that the regulation is not binding for most Korean banks, so they have room to increase or decrease their LDRs. In the following section, I would like to discuss whether those Korean banks with excessive bad loans should raise their LDRs. 

2. A Comparison of LDRs Between Korean Banks and Foreign Banks in the Domestic Market

Because there is a negative spread between the promissory interest rate on loans and the risk- free rate at domestic banks and because the foreign banks in Korea enjoy a positive spread, it would seem only logical that there should be some differences in the LDRs between domestic banks and these foreign banks. In this paper, I use the LDRs of foreign banks' branches in Korea for comparison with the Korean banks' LDRs even though foreign and Korean banks face different business environments. The branches of foreign banks are quite free to set their promised loan interest rates independently, but Korean banks must still of course abide by the interest rate regulations.

For the period of 1993 through 1995, the average LDR at the foreign bank branches in Korea marked a declining trend. They fell from an average of 83 percent in 1993 and 82 percent in 1994 to 76 percent in 1995. Korean banks, too, experienced a similar decline. However, the LDRs for trust accounts at foreign banks rose during this time, whereas at Korean banks they fell.

The differences in the LDRs for all bank accounts between foreign bank branches and Korean banks narrowed from a difference of five to seven percentage points in 1993 and 1994 to only two percentage points in 1995. The difference in the trust account LDRs, on the other, hand, widened greatly from 15 percentage points in 1993 to 38 percentage points in 1995. Only did the LDRs of the regular bank 

accounts of the two groups show similar patterns. Foreign bank branches in Korea naturally prefer issuing loans over investment in securities in their asset management for the simple reason that they can charge loan interest rates which are higher than the risk- free rate.

With the exception of Citicorp and Bankers Trust Company, the foreign banks in Korea are not heavily engaged in the trust business. Citicorp alone accounts for a tremendous 88 percent of all trust business handled by foreign banks in Korea, and BTC accounts for another 9 percent. The simple LDR of Citicorp's trust accounts is 81 percent while that at BTC is 0 percent. These banks also have greatly different LDRs for their regular bank accounts as well.

When I compare the simple LDRs of domestic banks with those of the branches of foreign banks., I find that in both cases, the LDRs are higher for bank accounts than for trust accounts, but among domestic banks, the deviation in simple LDRs is smaller than for the foreign banks.

These findings have two major implications. First, it seems reasonable to assume that the LDRs of the domestic banks will rise to about the same level of those of the foreign banks if domestic banks are permitted the same freedom as the former to set loan interest rates. Second, the LDRs of domestic banks will show greater variance in coming years as these banks continue to develop and become more differentiated from each other. 

3. The Differences Between the LDRs of Bank Accounts and Trust Accounts

It is puzzling that the average LDR for bank accounts should be more than double that of trust accounts even though the loan interest rate on bank accounts is two percentage points lower than that on trust accounts. Why should this be? Whatever the reason is, our discovery of it should help us determine the proper LDR for Korean banks.  Following is discussion of four possible answers to this question:

First, the effective yield on loans in bank accounts may exceed that on trust accounts even though the promissory loan interest rate on bank accounts is lower than that on trust accounts. However, it is highly doubtful that the effective yield on 

bank accounts exceeds that on trust accounts consistently.

Second, the percentage of customers at a particular bank who take out loans and who also hold deposits at the same bank account may be higher than that of loan customers who hold trust accounts. The higher percentage of the former group seems to result in a higher LDR. 

Third, the higher promissory loan interest rate on trust accounts dampens demand for loans in trust accounts. Loan customers in a strong bargaining position vis- a- vis the bank may be more likely to apply for loans from bank accounts than trust accounts because they will not be subject to the higher promissory loan interest rate. It has been found that 30 percent of loan customers at Korean banks are large corporations, 40 percent are small and medium- sized companies, and the remaining 30 percent are households. The fact that large corporations which hold trust accounts generally do not take out loans does much to explain the 40 percent discrepancy in LDRs between bank and trust accounts.

Finally, the asset managers responsible for handling trust accounts do not prefer loans to securities since they do not receive any credit on the accompanying revenues by loans. They are only concerned about the promissory loan interest rate, which is usually below the yield on fixed income securities. The fact that trust account asset managers allocate funds to loans only when the promissory loan interest rate exceeds the yields on alternative assets may also explain the lower LDRs of trust accounts.

It is not quite clear which of these four factors mentioned above is most responsible for the discrepancy in LDRs between the bank and trust accounts. If it turns out that it is the higher promissory loan interest rate which is the major cause, then the discrepancy would disappear if the promissory loan interest rate on trust accounts should become the same as that on bank accounts. 

I believe that the customer factor outweighs the yield factor in explaining the discrepancy. To support this, I need data on the effective yields and the number and 

percentage of customers who both take out loans and hold deposits. Unfortunately, these data are not yet available. 

4. The Criteria for Determining the Optimal Volume of Loans 

1) Optimal Asset Allocation

The primary criteria for determining the optimal volume of loans can be found by examining the return- risk matrix of the alternatives. The return- risk matrix can be computed from the yields on bank assets. It should be noted, though, that the computing work is made a good deal more difficult by the fact that the effective yield and the nominal yield are often different. For example, the effective yields on loans may be quite different from the promissory loan interest rates due to the prevalent use of compensating balances in practice.

According to Kim (1996), the realized yields on loan assets at the five largest commercial banks in Korea were lower than the yields on monetary stabilization bonds for the period of 1990 to 1995. This resulted from the facts that low- interest policy loans accounted for high percentages of total loans at these five banks, and that these banks were carrying huge burdens of non- performing loans. Here, the realized yields are computed as interest revenues divided by average volumes of loans.

It is quite unusual for loan yields to be lower than the risk- free rate in the major advanced countries. Why then should the LDRs of Korean banks be as high as those of foreign banks? 

Kim (1996) assumed that the effective yields on loans at Korean banks were about two percentage points higher than risk- free rate which is consistent with the average risk premium at the banks in the major advanced countries. Without such an 

assumption, one would conclude that the optimal ratio of loans to other earning assets is zero. By simulation Kim finds the optimal ratio of loans at Korean banks to be around 70 percent. Shin (1994) started with optimal asset allocation assuming that the ratio of loans to income earning assets is 70 percent. A utility function of banks is needed without a fixed ratio of loans: he contended that fixing the ratio of loans is simpler than to define a utility function of banks.

Previous studies on optimal asset allocation at banks have shown that the effective yields on loans should be higher than the risk- free rate. Otherwise, the optimal loan ratio would fall to zero. Interestingly, though, I suspect that in Korea the effective yields on loans may be lower than the risk- free rate. Since the lack of data on the effective yields on loans prevents me from using the optimal asset allocation method, I discuss qualitative factors rather than quantitative factors. 

2) A Case of Loan Customers with Deposits at the Same Bank

This section considers a case where customers who take out loans and simultaneously hold deposits at the same bank to explain the high levels of LDRs at Korean banks. This case seems inconsistent with the traditional banking theory according to which banks take in deposits from savers and give out loans to borrowers. In principle, the savers and borrowers are not the same customers, but a significant fraction of loans at Korean banks seems to be connected to deposits. The composition of loans connected to deposits can be regarded as the minimum required ratio of loans to deposits. 

Banks are unique because they deal with both deposits and loans while other financial institutions engage in only one or the other. The businesses of handling deposits and loans are complimentary to each other since there exists some degree of economy of scope between them. The fact that banks can engage in both of these businesses simultaneously may give them a competitive edge against other types of financial institutions. For example, banks can obtain information on the borrowers' financial conditions by simply looking at the deposit accounts of their own borrowers. 

Borrowers generally make their deposits in the same banks from which they have received loans so as to improve the prospects of their being approved for loans in the future. It has been found that heavier regulation of interest rates induces a higher percentage of customers to borrower and make their deposits at the same banks since banks try to increase the effective loan interest rate through compensating balances. The greater the difference between the promised loan interest rate and the market interest rate, the higher the percentage of customers who both borrow and deposit. Clearly, the corresponding percentages at Korean banks should be higher than those of foreign banks as the latter operate under a freer interest rate environment.

The depositors may make deposits in bank accounts which offer lower rates of interest than other alternative financial assets for either one of two reasons. The first is the transaction motive in the case of demand deposits. The second is the loan- seeking motive in the case of savings and time deposits. The main focus of banks' marketing activities for deposit- taking is based on the promise that depositors can get loans.

If the hypothesis holds that savings and time account holders are seeking loans from the same banks where they make their deposits, then the minimum required volume of loans would be roughly the same as that of savings and time accounts. However, the situation at one particular Korean bank provides a counter example to this hypothesis: the ratio of a line of credits to total loans is only 31 percent. Because this particular bank is a leading bank in such a loan market, the percentages of borrowing and depositing customers at other Korean banks are even lower than 30 percent. Thus, I can conclude that the hypothesis of borrowing and depositing customers fails to explain the existence of the major portion of loans. 

Even though this hypothesis cannot be a major criteria for determining the proper ratio of loans, it nevertheless provides us some insights into the banking industry in Korea. For those loans which are connected with deposits, the promised loan interest rate is not as important as the spread between the loan and deposit rates. As long as there exists a positive spread, banks can increase profits by this combination of loans and deposits. With this mechanism, neither banks nor borrowers are as interested in 

the absolute level of the interest rates on deposits and loans as much as in the spread between the two. 

The banks' incentive to expand the volume of these kinds of loans and deposits partially explains the existence of loans whose yields are lower than the risk- free rates. Even though loans are dominated by risk- free assets in terms of the return- risk matrix, banks are induced to increase the volume of loans as long as marginal income from deposits connected with loans remains positive. Clearly, banks which serve customers who borrow and deposit at the same bank need to maintain similar ratios of loans to deposits in order to keep those customers. 

If I adhere to the premise that optimal asset allocation will lead to zero volume of loans if the yields on loans are lower than the yields on risk- free assets, I will be hard- pressed to explain the fact that banks have rather high LDRs. The case considered in this section explains the existence of part of the volume of loans that banks maintain when those loans are dominated by risk- free assets in terms of the return- risk matrix, but it cannot explain the entire volume. There are clearly other reasons that explain the greater percentage of the existing loans.

3) Long- term Customer Relationships

In general, long- term customer relationships help raise the value of firms. In the banking industry, I recognize this positive correlation between long- term customer relationship and bank value. 

The loan business requires stronger customer relationships than the securities investment business. The strength of the customer relationship mainly depends on the frequency of repeat business. There is obviously more repeat business in the loan business than in the securities investment business, and this difference in the customer relationship between the loan and securities investment businesses may be one reason why bank managers consider the former more important than the latter.

The main bank system is regarded as an institutionalized form to strengthen long- term customer relationships. However, the main bank system in Korea had been used basically to control credits to the large corporations, but it is undergoing a change from being a tool for credit control to a mechanism that strengthens 

relationships between banks and customers. Some domestic banks have attempted to extend the main bank system even to retail banking. 

Those customers who are in better bargaining positions tend to change banks whenever competitors offer better deals. Of the three major groups of customers indicated earlier (large corporations, small and medium- sized companies, and individuals), large corporations have the strongest bargaining positions with the banks. They are therefore the least loyal of all customers to any particular banks, which implies that banks whose main customers are large corporations in their loan operations should have a lower loan/asset ratio than the industry average. 

Since the 80's, banks in some advanced countries have had to make use of preferential pricing systems instead of charging all customers the same price in order to keep their best customers who had access to alternative financial instruments which became available due to financial deregulation. The best customers have been quick to avail themselves of financial services and products offered by other types of financial institutions whenever they have considered them to be more valuable than those offered by the banks. Hereinafter, I shall refer to this phenomenon as disintermediation.

I conjecture that the more value the bank managers place on long- term customer relationships, the higher the LDR is. This is not yet proven, but this seems a reasonable conjecture. If this conjecture holds, then the LDR will decrease in the future if customer relationships are then considered of lesser importance.

4) Practices and Beliefs of Bank Managers

As for the optimal volume of loans, the external factors which influence the bank manager's judgement may be regulations, the demand for loans, and the asset yields, while the internal factors may be bank manager's own beliefs, the bank's funding capacity, and the composition of the bank's customers.

I have already discussed these factors in so far as they explain the high level of LDRs at Korean banks even though loans are regarded as inferior to risk- free assets in terms of the return- risk matrix. This requires us to check the possibility of practices and beliefs of the bank managers to explain the existence of loans.

It may very well be that the volume of loans at a bank is driven up because loan approval is widely viewed as a source of power and prestige. The compensating scheme based on seniority at Korean banks has more or less helped to make this practice prevalent. If loan officers instead of executive directors had the authority to approve loans, they would less likely be influenced by non- technical and seemingly irrelevant factors such as political connections in making their loan decisions. This would cause the loan/asset ratio to decline. 

Since the Hanbo scandal, many Korean banks have made serious efforts to overhaul their systems and practices for loan approval in the interests of better credit management, ultimately their own survival. The banks are placing the entire machinery of the loan approval process in the hands of more professional and independent groups, so the banks will no longer treat loan approval as a tool of power and prestige in the future.

Furthermore, additional revenues such as compensating balances and fee revenues are disappearing as the pricing scheme is being changed from a packaged to an unpackaged system. This change itself will make long- term customer relationships less important, resulting in a lower loan/asset ratio. 

Loan operations are believed to be commercial banks' source of competitive advantage against other types of financial institutions.  This is only true, however, if loan operations are actually profitable. If loan operations are incurring losses, then banks should either turn those operations around to profitability or allocate fewer resources to them.

5. The LDR and Related Variables

Using cross- sectional data of Korean commercial banks for 1996, I computed the correlation coefficients between the LDR and the capital ratio, bad loan ratio, the composition of loan customers, and the composition of savings and time deposit customers to learn how these variables influence the Korean banks' LDR. 

It is shown that the capital ratios are negatively correlated with the LDRs, contrary to our expectation. Furlong (1994) observed a positive correlation between the capital ratio and loan growth rate at U.S. banks in the 1990's, and he attributed 

this to the strong capital ratio regulation. I am not sure whether the capital adequacy regulation is yet affecting Korean banks' asset behavior. Or maybe the negative correlation is due to the definition of the LDR where capital is included in the denominator. 

The ratio of corporate loans (commercial loans) out of total loans shows a positive correlation with the LDR. However, the ratio of loans taken out by small and medium- sized corporations to total loans shows a negative correlation with the LDR, while the ratio of large corporations' loans to total loans shows a positive correlation with the LDR. 

The ratio of bad loans to total loans is found to be negatively correlated with the LDR. Non- performing loans do not contribute to the banks' revenue flows. The higher the ratio of non- performing loans to total loans, the more severe the financial distress of the banks. Those Korean banks with high ratios of non- performing loans will experience declines in their LDRs in the coming years. 

The ratio of savings and time deposits to total deposits is shown to have a positive correlation with the LDR. This positive correlation partially supports the hypothesis concerning customers who both borrow and make deposits at the same bank. 

III. The Comparison of Loans between Domestic and Foreign Banks

1. The Ratio of Total Loans to GDP and M₂

Loans are regarded as the riskiest of all of a bank's assets. Hence the ratio of loans to total assets has bearing on a bank's soundness. In order to help determine the proper loan/asset ratio, I compare the loan/asset ratios of domestic banks with those of foreign banks. Using the data for 1980, 1990, and 1995, I compare the composition of loans at commercial banks in Korea, Japan, and the U.S. with the figures for GDP and M₂ of each country. 

Tables 1 and 2 show that the loan/asset ratio to GDP in Korea was significantly 

lower than that of Japan. Table 3, however, shows that the ratio in the U.S. was roughly the same as Korea's. According to the data from these three countries, the loan to GDP ratio has increased steadily over time. It is not clear whether the ratio in Japan will converge to the level in Korea and the U.S.. 

Tables 1, 2, and 3 show that the ratio of loans to M₂ in Korea was higher than that in Japan or the U.S. for the entire period. Two conclusions may be inferred from these findings. First, the growth potential of the loan market in Korea is high if the Korean economy is more similar to the Japanese economy than the American economy.  Second, the ratio of loans to M₂ decreases when M₂ increases in Korea. 

<Table 1>Korean Deposit Money Banks

            (billion won)

Source: The Bank of Korea, Monthly Bulletin, various issues. 

<Table 2>Japanese Nationwide Banks

           (billion yen)

Source: The Bank of Japan, Monthly Bulletin, various issues. 

<Table 3>   U.S. Commercial Banks

         (billion dollars)

Source: Federal Reserve Board, Federal Reserve Bulletin, various issues. 

2. The Growth Rate of Total Loans Compared to GDP and M₂

Tables 4, 5, and 6 show that for the period from 1980 to 1995 the growth rate of total loans at Korean deposit money banks exceeded that of GDP by 2.34 percentage points. The difference between the two growth rates in Japan was 4.23 percentage points while that in the U.S. was 1.63 percentage points.

The difference between the growth rates of total loans and M₂ for the same period in Korea was only 0.13 percentage points. That in Japan was 2.13 percentage points, and that in the U.S. was 2.94 percentage points. 

<Table 4>    Growth Rates of Total Loans, GDP, and M₂ in Korea

         (percent)

Source: The Bank of Korea, Monthly Bulletin, various issues. 

<Table 5>    Growth Rates of Total Loans, GDP, and M₂ in Japan

(percent)

Source: The Bank of Japan, Monthly Bulletin, various issues. 

<Table 6>    Growth Rates of Total Loans, GDP, and M₂ in the U.S.

         (percent)

Source: Federal Reserve Board, Federal Reserve Bulletin, various issues. 

Table 7 shows that the annual growth rates of total loans in the three countries were higher than the growth rates of GDP and M₂ during the 15- year period, and the growth rates of total loans, GDP, and M₂ in Korea exceeded those in Japan and the U.S. However, as for the relative growth rates of total loans, that is the difference between the total loan growth rate and the GDP and/or M₂ growth rates, the difference between the growth rates of total loans and GDP is greatest in Japan and lowest in the U.S., while that between loans and M₂ was greatest in Japan and lowest in Korea.

<Table 7>  Comparison of Growth Rates in Korea, Japan, and the U.S.

        (percent)

IV. Concluding Remarks

This paper investigates several factors, widely considered as having influence on the loan/asset ratios at Korean banks. I start this study under the premise that the loan operations at Korean banks may not be profitable because commercial banks are prohibited from charging interest rates which are high enough to cover the loan loss rate in Korea. 

At this point in time, the optimal method of asset allocation based on the return- risk matrix cannot be used to determine the proper volume of loans for Korean banks due to the lack of necessary data on the effective yields of loans. I therefore have no option but to resort to some qualitative discussion to discover reasonable criteria on the optimal volume of loans.

The hypothesis of same customers of deposits and loans supports the holding of loans even when loans are dominated by other assets in the return- risk matrix. 

However, this hypothesis fails to explain the existence of the major portion of loans. The ratio of customers who both borrow and make deposits at the same bank will decline as compensating balances fade out.

Long- term customer relationships have not been considered important by prime customers. This weaker customer relationship leads banks to change their pricing from a packaged system to an unpackaged system. The volume of loans resulting from long- term customer relationships will decline as such relationships are granted less and less importance.

The belief that loan operations are a source of power and prestige and that other financial services are less important is beginning to change, especially in the wake of the Hanbo scandal.  Instead, a more rational and business- like attitude towards loan operations is coming into being with the result that the ratio of total loans to total assets is declining.

The finding that the LDR is negatively correlated with the bad loan ratio suggests that those Korean banks which are saddled with especially heavy burdens of bad loans will have no choice but to reduce their LDRs. The disintermediation process will also force LDRs down since the ratio of large corporate loans to total loans is positively correlated with the LDR. 

All told, the LDRs at Korean banks should decline in the coming years. Even though I am unable at this time to provide a quantitative answer to the question of what is the optimal volume of loans at banks, the available evidence suggests that Korean banks' current LDRs are higher than they should be, thus posing significant and unnecessary risks.

References

<Korean References>

Kim, Sunho, “On the Optimal Level of Stock Investment For Korean Banks,” Financial Studies, Korea Institute of Finance, August 1996, pp. 1- 34.

Shin, Sungwhan, “On Optimal Fund Allocation in Security Investment for Korean Banks,” Quarterly Financial Review, Korea Institute of Finance, December 1994, pp. 1- 32.

Lee, Youngsoo, “The Changes in Lending Behavior at Banks,” Korean Journal of Money and Finance, December 1996, pp. 71- 96.

<English References>

Fama, E.F., "What's Different About Banks?" Journal of Monetary Economics, 1985, pp. 29- 39.

Furlong, F.T., "Capital Regulation and Bank Lending," Economic Review, Federal Reserve Bank of San Francisco, 1992 No 3, pp. 23- 33.

Himmelberg, C.P. and D.P. Morgan, "Is Bank Lending Special?" Federal Reserve Bank of Boston, Conference Series No. 39, June 1995, pp. 15- 36. 

Keeton, W.R., "The Impact of Monetary Policy on Bank Lending: The Role of Securities and Large CDs," Economic Review, Federal Reserve Bank of Kansas City, Second Quarter 1993, pp. 35- 47.

Moore, R.R., "Bank Lending and Bank Capital: A Panel Data Assessment of Market and Accounting Values," Federal Reserve Bank of Dallas, Financial Industry Studies Working Paper, March 1994.

Morris, C.S. and G.H. Sellon, "Bank Lending and Monetary Policy: Evidence on a Credit Channel," Economic Review, Federal Reserve Bank of Kansas City, Second Quarter 1995, pp. 59- 75.

Peterson, M. and R. Rajan, "The Benefits of Lending Relationships: Evidence from Small Business Data," Journal of Finance, 1994, pp. 3- 38.

Macroeconomic Developments

Economic Growth 

Economic growth in the first quarter of 1997 hit one of its lowest points since the early 1960s. It was recorded at only 5.4 percent year- on- year (yoy), and most other indicators pointed to continuing deterioration of one kind or another. The current account deficit widened to a record quarterly high of 7.9 billion dollars, both investment and consumption were weak, and the unemployment rate rose to 2.6 percent, the highest level since the first quarter of 1994. What is more, many of the aggregate supply phenomenon which are typical of economic stagnation have become manifest as the recession has become more prolonged. The average factory operation ratio declined to 79.0 percent. The only good news was a dip in the inflation rate to a moderate 4.7 percent (yoy). 

The main cause of the economic slump of the first quarter was the contractions in investment and consumption. As shown in Table 1, the fixed investment decreased by 2.0 percent (yoy). While export growth rate recorded as high as 15.2 percent, it did not succeed in promoting equipment investment. Since the export price was down by more than 20 percent (yoy), the actual revenue and profits of the firms decreased significantly. Inventories have accumulated, creating more financial pressures on them. Many had no other choice but to postpone their facilities expansion projects. Construction investment has also been down with private housing construction falling off the most. As a result of over construction for the past few years, the excess supply in the housing market was still a problem in the first quarter and will remain so for some time to come. More than 90,000 apartments actually remain unsold throughout the country. Only public construction investment still continued to grow as usual because the Korean government has expanded its expenditures for construction in order to prevent the possibility of an even deeper recession and to make much needed improvements to the infrastructure.

Because this recession has now been dragging on for the better part of two years, private consumption has finally begun to decelerate. Consumption growth rate in the 

- 22 -

first quarter fell to 4.4 percent from 6.5 percent (yoy) in the fourth quarter of 1996. More and more consumers began to recognize the seriousness of the current recession and tried to reduce spending. Usually, changes in consumption growth lag changes in production growth by several quarters. 

While the export sector showed a relatively good performance, it was still moving on the declining trend. As shown in Table 1, the growth rate in exports fell to 15.2 percent (yoy) in the first quarter from 18.5 percent (yoy) in the fourth quarter of 1996. The major cause of it has been the worldwide surplus of Korea's major export products, especially semiconductors, but the depreciation of the Japanese yen and the rise of other developing countries have been factors as well. Many of Korea's products, especially its capital- intensive ones, compete directly with Japanese products and therefore become less price competitive when the yen falls. Most adversely affected by the yen's decline were exports of electronics and automobiles. Korea is also losing its market share in the world economy for labor- intensive products. The fact is that many other developing countries are moving into labor- intensive manufacturing and have access to much cheaper labor.

Production activity declined as the recession deepened and inventories accumulated. Many firms experienced cash- flow problems, and there was a higher incidence of 

<Table 1>                     Economic Growth¹⁾ 

(percent)

Notes:  1) Percentage changes from the previous year.

2) Estimates.

3) KIF Forecasts. 

Source:  The Bank of Korea, National Income, various issues. 

- 23 -

bankruptcies. The most sensational bankruptcies were those of the Hanbo and Sammi

groups. They are among Korea's thirty largest conglomerates, and their collapse sent repercussions throughout the entire financial sector. Interest rates rose, and the availability of financial resources contracted suddenly. More than anything else, however, these two bankruptcies dealt a serious blow to confidence in the overall economy. 

As the decline in export price is the main cause of the current recession, some economists insist that it is necessary for Korea to pursue far- reaching industrial restructuring. They point out that the bulk of Korea's exports are produced by only a 

few industries such as the electronics and petrochemical industries. In addition, many firms have argued that the regulatory regime is so onerous that it restrains business activity. They insist that the government should therefore remove all unnecessary regulations in the interest of economic efficiency and Korean industry's greater competitiveness on the world market.

<Figure 1>   Real Effective Exchange Rate and Export Growth Rate¹⁾

Note:  As for the actual estimation of real effective exchange rate, see the Korean

Financial Review, Spring 1996, Vol. 6, No. 1. 

Source:  The Bank of Korea, Monthly Bulletin, various issues.

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IMF, International Financial Bulletin, various issues.

<Table 2>                  Industrial Activity Index¹⁾

(percent)

Notes:  1) Percentage changes from the previous year.

2) Seasonally adjusted.

3) Percentage changes from the previous period.

Source:  National Statistical Office, Industrial Activity Review, various issues.

<Figure 2>     Capital Stock Adjustment Pressure and Equipment 

Investment Growth Rate¹⁾

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Note:  Capital Stock Adjustment Pressure = Production Growth Rate － Production Capacity Growth Rate. Hereafter second quarter of 1997, equipment investment is KIF forecasts.

Source:  Bank of Korea, National Accounts, various issues.

The continuing deterioration in the terms of trade has hurt the profits of most firms. Korea imports most of its raw material needs while it exports final products. Any deterioration in the terms of trade will therefore cause firms' revenue to decline and, conversely, their costs to increase. This is especially a problem considering the fact that Korean firms have long upheld the tradition of lifetime employment and are still reluctant to layoff workers en masse. Their labor costs have not changed much as a result, despite the steep declines in revenue. Furthermore, the depreciation of the won has caused Korean firm's debt burdens to increase. Many Korean firms had taken out loans from the international financial markets in recent years, and the won's recent depreciation has meant not only higher principles, but also higher interest payments.

During the second quarter of 1997, the Korean economy will continue to plod along. Neither exports nor investment are expected to recover significantly just yet. The GDP growth rate will remain as low as 5.8 percent, the average factory operation rate will fall further, private consumption and investment will remain weak, and the unemployment rate is expected to rise above 3.0 percent. Though the financial markets may recover and interest rates will be low, this will not be enough to dispell the lack of confidence in the economy. In Korea, business confidence or the investment environment are clearly more 

- 26 -

<Figure 3>      Equipment Investment and Production Capacity

Sources:  National Statistical Office, Monthly Statistics of Industrial Production, various issues.

The Bank of Korea, National Accounts, various issues.

important in firm's investment decisions. 

The current recession is now expected to continue through all of 1997. The GDP growth rate should be about 6.1 percent in the second half of 1997. The global excess supply of Korean export products and the steep depreciation of the yen in the first quarter will preclude a rapid export recovery. This will also discourage firms from investing in production facilities. Investment decisions of Korean firms heavily depend upon the demand for exports, something which is underscored by the fact that more than half of Korea's GDP is derived from international trade. In the construction sector, investment is projected to maintain its current growth rate. As previously stated, there are more than 90,000 unsold apartments around the country, and this does not bode well at all for the housing construction industry. Consumption is forecast to decelerate further. As more consumers realize that the recession will continue for the time being, they will increasingly economize on expenses. The slowdowns in consumption, investment, and production will in turn lead to yet slower growth in imports, which will be reflected as an improvement in the current account deficit. Taking all of these factors duly into consideration. 

The above forecasts are in line with the latest movements of major leading economic indicators. The composite leading business indicators increased by only 0.4 

- 27 -

percent in the first quarter of 1997. This shows that the Korean economy will still be weak during the second and third quarters of 1997. The growth in the volumes of machinery imports and domestic machinery orders, leading indicators of equipment investment, remained flat or decreased during the first quarter, which likewise indicates that equipment investment will not recover in the near future. The growth in arrivals of letters of credit, the leading indicator of exports, also kept decreasing during the first quarter. No major recovery in exports can realistically be expected until sometime in 1998 at the earliest.

Prices

The growth in the CPI in the first quarter was recorded at 4.7 percent (yoy), which is down slightly from 4.8 percent (yoy) in the fourth quarter of 1996. Due to the increased demand for agricultural and consumer goods for celebration of the lunar new year, CPI growth peaked at 4.9 percent in February before falling back to 4.5 percent in March. Increases in prices for manufactured products accounted for 1.8 percentage points of the rise, fees for services accounted for 2.2 percentage points, and agricultural product prices accounted for 0.6 percentage points.

Evidently, as has been the case for a long time now, the greatest source of upward pressure on the CPI was still increases in service fees, but even they began to decelerate during the quarter. The 20- month long recession has eased demand pull pressure greatly. Another factor which did much to check inflation was the slowdown in wage increases. It was widely accepted that high wages were one of the Korean economy's major problems, if not its most important problem, so firms had announced more modest wage increases for 1997 and in some cases actually froze them. This was a significant development because even the labor unions have given their consent to it, although the rising unemployment rate was clearly discouraging rapid wage increases as well.

The rise in prices for manufactured products stemmed partly from the depreciation of the Korean won and the imposition of higher taxes on fuels to raise funds for infrastructure improvement and to encourage fuel efficiency. 

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<Table 3>                       CPI and Wages¹⁾

(percent)

Notes:  1) Percentage changes from the previous year.

2) Estimates. 

3) KIF Forecasts.

Sources:  National Statistical Office, Consumer Price Index, various issues.

The Bank of Korea, Monthly Bulletin, various issues.

Ministry of Labor, Monthly Labor Survey, various issues.

The CPI is forecast to rise by 4.6 percent (yoy) in the second quarter. Though the weaker demand caused by the continuing recession will curb upward pressure on

service fees, the steep depreciation of the won during the first quarter will force prices of manufactured products up at the same rate as during the first quarter. Wages for their part will remain flat.

In the second half of the year, the CPI is forecast to rise more moderately by 4.2 percent. Many factors will work to keep inflation down. Not only is the government striving to hold inflation in check by various means, but the economic situation is now favorable as far as inflation is concerned. The continuing recession will further reduce the demand pull inflationary pressure, and the slower wage growth rate will decrease cost- push inflationary pressure. Some inflationary pressure will be absorbed due to an increase in imports of cheap consumption goods from other Asian developing countries, and the won will finally stop falling in the third quarter and then begin to appreciate, which will reduce the prices of imported goods.

- 29 -

<Figure 4>       CPI Inflation Rate and Sectoral Contributions

Source:  National Statistical Office, Consumer Price Index, various issues.

Current Account and Foreign Exchange Rate

The current account deficit widened to 7.9 billion dollars during the first quarter of 1997. This serious deterioration is seen as a result of not only the slowdown in exports but also negative seasonal factors in the trade balance and the continuing deficit in the invisible trade balance. 

Exports were actually down by 3.0 percent during the first quarter. This was mainly because of the decline in unit export prices, but the volume of shipments was off as well. The unit price of exports was estimated to fell by more than 20 percent (yoy) in the first quarter. The continuing global excess supply of Korea's major export products such as steel, semiconductors, and petrochemicals has not allowed prices to recover. At the same time, the depreciation of the yen has weakened the competitiveness of Korea's exports. The automobile and petrochemical industries are especially influenced by movements of the yen because they compete head- to- head 

- 30 -

with Japanese industry on the world market.

At long last, import growth finally began to slow in the first quarter. It fell into the single digits to only 6.1 percent (yoy). As the recession has now continued for the better part of two years, the adjustment in demand for imports which economists have been predicting for some time is now underway. The growth rate of consumer goods imports fell the most steeply, collapsing from 23.4 percent (yoy) in the fourth quarter of 1996 to only 2.8 percent (yoy). Private consumption was very weak, and the depreciation of the won has made imported consumer goods more expensive. It is known that the elasticities of import demand for consumer goods to both scale variables and relative price are greater than those of other import goods. Capital goods imports decreased by 1.3 percent (yoy) due to the slowdown in investment.

The deficit in the invisible trade balance expanded to 2.1 billion dollars in the first quarter. The deterioration of the current account for the past few years has forced Korea's total international debt up, in turn causing interest payments to foreign creditors to increase. The travel account also worsened as more Koreans took their vacations abroad.

The capital account recorded a surplus of 4.6 billion dollars in the first quarter. During January and February, only 2.2 billion dollars in capital inflows were recorded, but in March alone so inflows of as much as 2.7 billion dollars. There are several factors which explain this sudden increase. In January, most investors in the Korean financial market had expected the Korean won to depreciate because of the deterioration of the current account. They therefore tried to reduce or postpone their foreign borrowing. In addition, Korean financial institutions' accessibility to foreign financial sources rapidly deteriorated due to the high- profile bankruptcies of two of 

Korea's major conglomerates, Hanbo and Sammi, and the accumulation of bad loans at Korean commercial banks. Furthermore, the stagnation of the Korean stock market discouraged foreign investors from making additional purchases of Korean stocks. The situation changed greatly in March, however. The Korean financial markets significantly recovered, and as a result, many financial institutions, especially the Korea Development Bank, were able to take out large loans from the international financial market. 

- 31 -

The won slid from 843 won to the dollar to 897 won during the first quarter. The current account deficit marked a continuous rise, and the capital account surplus fell, putting 

<Table 4>          Balance of Payments and Exchange Rate

(billion dollars)

Notes:  1) Estimates.

2) KIF Forecasts.

3) Period averages.

Source:  The Bank of Korea, Monthly Balance of Payments, various issues.

constant depreciatory pressure on the won. The Bank of Korea occasionally intervened in 

an attempt to slow the won's decline, but market forces inexorably pushed the won

downward during most of the quarter. The foreign reserve/monthly import ratio fell to 2.5.

In the second quarter, the won is forecast to depreciate further against the dollar. The average won/dollar exchange rate during the period is projected at about 896.8. The current account deficit will remain a serious economic woe and will therefore continue to exert depreciatory pressure on the won/dollar exchange rate. However, as the financial market recovers from the shocks of the first quarter and the capital account surplus increases, the depreciatory pressure will begin to taper off. In fact, in the second half, the appreciatory pressure will build sufficiently such that the won should reverse itself and appreciate slightly. By the end of the year, the won is forecast to appreciate to about 880 per dollar. 

The depreciation of the Korean won increased Korean firms's debt burdens. 

- 32 -

Many firms which had financed their investments through the international market over the past several years have seen their total debts in won terms rise. Firms in the automobile and petrochemical industries were especially affected for the worse.

<Figure 5>       Balance of Payments and Exchange Rate

Sources:  The Bank of Korea, Monthly Balance of Payments, various issues.

The Bank of Korea, Foreign Exchange Market Review, various issues.

The current account deficit is forecast to narrow to 5.4 billion dollars during the second quarter. At this point in time, several factors will work to improve the deficit situation. Not only will import growth slow, but more importantly, the unit export prices for semiconductors and petrochemical products are forecast to stop falling and to be stable, because global demand will begin to recover, and major producers in Korea and Japan cut back their production. The competitiveness of Korean products, however, is not expected to recover. The depreciation of the yen and the increasing availability of cheap products from Asian developing countries are making the situation for Korean exporters more difficult, but there should still be modest improvement in Korea's export performance, nevertheless. 

The second half of 1997 should see further improvement in the current account. The deficit is forecast to moderate somewhat, falling to 8.4 billion dollars. The trade 

- 33 -

balance will improve substantially while the invisible trade balance will further deteriorate. By this time, the recovery in unit export prices and the acceleration of global economic growth will both help Korean exports to revive. The increasing price competitiveness of Korea's goods in the wake of the won's depreciation will also promote exports as well. Imports, for their part, are expected to slow down further as 

<Figure 6>   Won/Dollar Exchange Rate and Won/Yen Exchange Rate

Source:  The Bank of Korea, Monthly Balance of Payments, various issues.

the recession drags out. The ratio of the current account deficit to GDP in 1997 will decline to 4.2 percent from 5.0 percent in 1996.

The capital account is forecast to record a surplus of 4.0 billion dollars in the second quarter of 1997. The further opening of the financial markets will encourage significant inflows. The next three- percentage- point increase in the ceiling on aggregate stock holdings by foreigners on the 1st of May, for example, should induce capital inflows of 1.5 billion dollars during the quarter. This kind of financial opening will also do much to dispel expectations in the foreign exchange market of further depreciation of the won. As the Korean financial market recovers from the credit crunch sparked by the Hanbo and Sammi bankruptcies, Korean financial institutions will find that they will have much greater accessibility to the international financial 

- 34 -

market. 

The substantial influx of foreign capital should continue in the second half. The ceiling on aggregate stock holdings by foreigners will be raised by another two or three percentage points, and more foreign financial institutions will be permitted to participate in the Korean financial market. What is more, a greater number of Korean firms will be permitted to finance their investments through the international financial market.

- 35 -

Money and Interest Rates

Money Growth

The first quarter of 1997 certainly saw more financial turbulence than usual. The monetary indicators were mixed because of the high volume of transfers between different types of financial assets, the lowered reserve requirement ratio, and the back- to- back bankruptcies of the Hanbo and Sammi groups. The growth in MCT, which is now the primary indicator of the money supply, fell to 18.3 percent year- on- year (yoy). The MCT growth rate was 18.4 percent in January and 18.8 percent in February, but it fell to 17.8 percent in March. The MCT growth rate has generally been slowing since the second quarter of last year. It rose in January because the central bank supplied about five trillion won to commercial banks ahead of the lunar New Year Holiday to alleviate some of the financial tightness which occurred in the wake of the Hanbo and Sammi bankruptcies.

<Table 5>                  Monetary Growth Rates¹⁾

(percent)

Notes: 1)Year- on- year period average percentage changes. The figures for the first quarter of 1997 are preliminary. 

2)Reserve Money = bank notes + reserves of deposit money banks.

3)M1 = currency + demand deposit.

4)M2 = M1 + savings deposit + foreign currency deposit.

5)MCT = M2 + CDs + money- in- trust.

6)M3 = M2 + deposits in non- bank financial institutions + debentures issued +commercial bills sold + CDs + RPs.

Sources:  The Bank of Korea, Current Monetary Statistics, various issues.

The Bank of Korea, Monetary Trend during the First Quarter. 

- 36 -

The deceleration in MCT growth can be explained partly by the reduction in flows of funds into trust accounts. The reforms to the money- in- trusts system implemented last May induced a transfer of funds out of short- term trusts and into accounts at banks such as mutual installment accounts, and these flows continue to this day. Thus, the growth rate of money- in- trusts fell to 8.0 percent from 13.0 percent over the past year. As to other factors, the recession caused the national savings rate to decline, and the issuance of CDs has fallen off because the central bank imposed a reserve requirement on them. These development has of course pulled down the MCT growth rate as well.

The M2 growth rate was recorded at 19.4 percent (yoy) during the first quarter. Unlike MCT, the growth in M2 has been rising since the second quarter of last year, and this has been in great part due to the inflow of funds from short- term trust accounts into bank accounts. However, these flows could not entirely explain the acceleration in M2 growth. It was found that the velocity of the M2 money supply was actually twice that of MCT, so much of the monetary expansion was in fact due to the money creation process. The high M2 growth gave rise to concerns that the central bank might resort to a tight monetary policy.

- 37 -

The reserve ratio was reduced twice last year -  in April and November. This led to a roughly 16.0 percent decline in the volume of reserve money as reserve deposits have fallen.

The reduced monetary base caused the multipliers of each and every monetary indicator to increase in the first quarter while also reducing the velocities of money. The velocities show the frequency of transactions between financial assets and cash, and they generally fall as the economy grows. In the first quarter, it would seem that the lower volatility in interest rates and the slowdown in investment forced the velocities down even lower. 

Large amounts of money flowed into the economy through the private sector. These flows actually more than offset the declines in the amounts supplied through the government, overseas, and other sectors. What was especially interesting this quarter was that the overseas sector absorbed about 4.0 trillion won. The deficit in the current account balance for the period reached nearly 8.0 billion dollars, and 

<Table 6>                 Multipliers and Velocities¹⁾

Notes: 1)Money multipliers are the ratios of each monetary aggregate to the volume of reserve money. Velocities of money represent the ratios of nominal GDP of each monetary aggregate. 

2)Estimates.

- 38 -

Sources:  The Bank of Korea, Current Monetary Statistics, various issues.

The Bank of Korea, Monetary Trend during the First Quarter. 

capital inflows from overseas dropped off. Evidently, the Hanbo and Sammi 

bankruptcies made foreign investors wary of sending their capital to Korea, and this 

accelerated the won's depreciation, which meant that even more money would be absorbed by the overseas sector. Although the won had already been moving downwards before the Hanbo and Sammi debacle, it fell more steeply afterwards, reenforcing firms' expectations of yet further depreciation. They therefore decided to keep their reserves of foreign exchange in foreign currency accounts. In addition to 

all this, the stock market was very stagnant during the quarter, discouraging foreigners 

<Table 7>        Recent Deposit Changes at Financial Institutions¹⁾

(billion won)

Note:  1) Average changes during the period.

Sources:  The Bank of Korea, Current Monetary Statistics, various issues.

The Bank of Korea, Monetary Trend during the First Quarter. 

<Table 8>                  MCT Supply by Sectors¹⁾ 

(billion won)

- 39 -

Note:  1) End of period changes to the previous period.

Sources:  The Bank of Korea, Current Monetary Statistics, various issues.

The Bank of Korea, First Quarter Monetary Trends. 

from investing in it.

Two major policy changes were made for the call market and deposit reserve system in the first quarter. The call market was divided into a bank call market and a non- bank call market. This may have been a necessary change in the interests of long- term financial development, but in the short- term it gave rise to a couple of problems. It made the circulation of funds more costly, especially for those financial institutions, which always resort to the call market to raise operating capital. As intermediation institutions also use call money as operating capital, questions about fairness in intermediation were raised. The Korean Capital Intermediation Company was established in November 1996, and it took exclusive charge of call money intermediation on February 10, 1997. This solved some of the problems of the former call market system. More specifically, it allows the central bank to easily ascertain the availability of funds, so it can deal with fund shortages and other such problems in a much more effective way.

<Table 9>                     Balance of Payments

(million dollars)

Note:  1) Estimates.

Source:  The Bank of Korea, Balance of Payments, various issues.

<Table 10>                  Foreign Currency Deposits¹⁾ 

(billion won)

- 40 -

Notes:  1) Average balance. The figure for the first quarter of 1997 is an estimate.

Source:  The Bank of Korea, Current Monetary Statistics, various issues.

As financial liberalization proceeds, the central bank is increasingly making use of indirect means of monetary management. Among the several actions it took in the first quarter, it lowered the reserve requirement ratio to 3.5～4.0 percent from 5.5 percent and imposed a 2.0 percent reserve deposit requirement on CDs instead of abolishing the limit on CD issuance. In order to absorb the increased supply of money resulting from the reduction of the reserve requirement, the central bank then lowered the limit on aggregate loans to 3.6 trillion won from 6.4 trillion won. Banks should realize an additional 120～160 billion won in profits this year as result of this change, and it should also help pull down interest rates. The B2 money system, which had originally been established to penalize banks which failed to meet the reserve requirement, was also changed. Under this system, banks with insufficient reserves were required to receive money from the central bank at high interest rates, but this system was changed to help prevent short- term interest rates from soaring. Banks can now voluntarily borrow B2 money at market rates from the central bank within preestablished limits. The reduction of the reserve requirement may induce lower interest rates in that it will help improve the banks' profits. The reduction of the aggregate loan limit and the reform of the B2 money system can be understood as first steps away from quantity- based monetary management toward price- based monetary management.

The money supply as measured by MCT is expected to grow 17.3 percent in the second quarter, which is a slightly lower rate than during the first quarter. Although the second quarter usually witnesses an increase in investment, the demand for money will not increase much this year as the prolonged recession has forced most firms to postpone their investment plans. Furthermore, the CPI is expected to be stable around 4.6 percent (yoy), CD issuance will decline due to the new reserve requirement, and the overseas sector will continuously absorb money because of the huge current account deficit. Although a rise in stock investment by foreigners is expected, it will 

- 41 -

hardly be sufficient to pull the deficit down significantly.

Korea's financial sector has become increasingly influenced by the overseas sector. The limit on foreigners' aggregate portfolio investment is scheduled to be raised another three percentage points to 23 percent on May 1, but it will not likely induce more than 1 trillion won in additional inflows of foreign capital. Foreign investors were generally selling, not buying, in the first quarter, and fewer than 50 investment firms' exhausted their limits on portfolio investment. Domestic banks' and firms' credit ratings were adversely affected by the Hanbo and Sammi bankruptcies, but they will begin to rise again in the second quarter, and capital inflow through bond issuance will increase. The current account deficit for the second quarter is expected to be about 5 billion dollars. Though this is a significant decline, the overseas sector will still continue to act negatively on the money supply, especially as the current account balance influences foreign capital flows more so than any other indicator.

The M2 growth rate during the second quarter will be about 20 percent. This is a slight decline from first quarter and will be closer to the MCT growth rate. It will peek at 21 percent in April due to a rush of inflows to bank accounts from trust accounts. These flows have been continuing for almost an entire year, but they will finally cease in May. The central bank will target the MCT growth rate at around 17 percent, depending upon the movements of interest rates and the exchange rate, so there will be no major monetary contraction or expansion. In the beginning of the year, the MCT growth target was initially set at 17.5 percent +/-  2.5 percent in expectation of 6.0 percent GNP growth, 4.5 percent annual inflation, and a 7.0 

<Table 11>            Monetary Growth Rates and Forecasts¹⁾

(percent)

- 42 -

Notes: 1)Year- on- year growth rate of the average balance.

2)Estimates.

3) KIF Forecasts.

Sources:  The Bank of Korea, Current Monetary Statistics, various issues.

The Bank of Korea, Monetary Trend during the First Quarter. 

The Bank of Korea, Monthly Bulletin, various issues.

percent decline in monetary velocity. Later, however, the central bank downwardly revised its forecasts for the GDP growth and inflation as the recession dragged out and the current account balance deepened. The MCT growth target was therefore lowered to 17.0 percent.

Interest Rates

Interest rates were generally on the rise throughout the first quarter. They had been declining, but the bankruptcies of the Hanbo and Sammi groups roiled the markets and sparked serious concerns about the state of the Korean economy at large. Fears of monetary contraction spread widely, but the demand for money remained stable because firms were also cutting back their investment. Korean firms and financial institutions suffered a blow to their credibility on the international market due to the Hanbo and Sammi bankruptcies, and the CB yield gap between issuing institutions and guarantee institutions became much wider.  Firms' short- term financing needs also forced the yield on CP up sharply. Although the central bank took action to expand the money supply, financial institutions assumed a conservative posture in their lending in order to protect themselves from future possible bankruptcies. Many 

firms suffered a credit crunch as a result, but the call rate did become stable.

<Figure 8>                Major Interest Rates 

- 43 -

The market interest rates fell in January due to seasonal factors, but they rebounded sharply after the Hanbo Group announced its insolvency and the central bank intervened in the foreign exchange market to prop up the won. The interest rates continued to rise thereafter until mid March because of the high MCT growth rate, high demand for money ahead of the Lunar New Year, and fears that the central bank might pursue a tight monetary policy. Afterwards, the interest rates began to fall again because central bank made assurances that it would work to expand the money supply. The CB yield (3 year maturity) fell back to 12.5 percent by the end of the March.

<Figure 9>            Major Short- term Interest Rates 

- 44 -

<Table 12>                Major Interest Rates by Quarter

(percent)

Source:  Korea Investors Service, KIS- LINE.

The changes in the demand and supply of money had little influence on the interest rates during the first quarter. On the demand side, gross fixed capital formulation grew only 4.0 percent, which was much lower than during the first quarter of last year. The net issuance of CBs was only half the amount recorded during the same period last year. On the supply side, the MCT growth rate fell by 2.5 percentage points to 18.3 percent.

The rise in interest rates was essentially caused by financial institutes' defensive behavior. In addition to the Hanbo and Sammi groups, some electronics firms and other firms which were subsidiaries of large firms also experienced serious financial difficulties. The rate of dishonored bills rose to 0.23 percent, the highest since the 

- 45 -

late 80's. This, in addition to the consecutive bankruptcies, was partly a result of stagnation in sales in the face of an increased supply of stock. Financial institutions became very conservative in issuing loans and in guaranteeing CBs, thus creating tightness in the money market. The tightness was actually so great at one point that some firms, for example, were not even able to get any guarantee from financial institutions and had to forego their plans to issue CBs altogether. That interest rates should have risen so quickly therefore comes as no surprise. It is also noteworthy that the yield gaps between financial institutions varied greatly. Those banks which had extended the largest loans to the Hanbo and Sammi groups saw the credit ratings 

<Table 13>                  Determinants of Interest Rates

(percent, billion won)

Notes:  1) Year- on- year growth rates.

2)Estimates. 

Sources:  The Bank of Korea, Monthly Bulletin, various issues.

Korea Investors Service, KIS- LINE.

decline substantially. The CB yields guaranteed by these institutions were about 0.5 percent higher than those of other CBs, and the yield gaps between CBs guaranteed by securities companies and banks also widened. As financial institutions became more cautious in extending loans to firms, their money positions improved, and the

<Table 14>               Rate of Dishonored Bills

(percent, number)

- 46 -

Sources:  The Bank of Korea, Current Monetary Statistics, various issues.

The Bank of Korea, The Ratio of Dishonored Bills in March.

Korea Investors Service, KIS- LINE.

<Figure 10>          CB Yields by Guarantee Institutions 

call rate fell by 1.8 percentage points to 12.02 percent. Expectations of monetary contraction were finally dispelled in February when it was reported that the MCT growth rate and first quarter M2 growth rate had risen. These expectations had also contributed to the earlier rise in interest rates.

Much of the uncertainly that plagued the financial markets dissipated when the government announced that it would take action to restore financial stability. Most financial institutions then became less conservative in their lending to firms. By this 

- 47 -

time, it was obvious that the Hanbo and Sammi bankruptcies were not going to pull the financial system down and that rumors of bankruptcies of other large firms had been overblown. The central bank decided not to absorb money and affirmed that it would let the money supply grow. Thus, fears of a financial crisis eased greatly, and the interest rates began to fall. 

The yield curve remained downward sloping throughout the first quarter, although it did become nearly flat late in the quarter when the interest differential between bonds of different maturities became narrower. It shifted downward in January and February without changing slope, and in March, the interest rate on 91- day CDs fell while the call rate rose. The interest rate on CDs fell because a reserve requirement was imposed on CD issuance, causing it to contract.  The call rate rose due to 

<Figure 11>                First Quarter Yield Curve

widespread fears of monetary contraction. It was still nevertheless remained at a relatively low level because the central bank supplied financial institutions sufficient amounts of money.

The availability of money at financial institutions also explains the lower volatility of interest rates in the first quarter. Even though they did rise and then later fell and 

- 48 -

the financial market experienced a severe contraction, they were actually less volatile than during the previous quarter. It is true that the credit risks rose, but instead of raising interest rates further, this led financial institutions to refuse many loans. Financial institutions refrained from extending loans and guarantees and discounting CP for any but the most stable firms. Consequently, the volumes of CB issued and CP discounted fell, thus precluding the possibility of wide fluctuations in interest rates.

The reform of the call market system was one of the major institutional changes in the financial sector during the first quarter. For the first few months after it opened in November of 1996, only 10- 20 percent of all call transactions were handled the Korean Capital Intermediation Company; merchant banks handled the rest. In January, however, that percentage rose steeply to 80 percent, and since February 10,

it has handled 100 percent of all such transactions. In the beginning, the call rates offered by the intermediation company were about 0.5 percent above those offered by merchant banks as the latter were able to charge lower transaction fees. However, as the percentage of all transactions through the intermediation company rose, economies of scale began to obtain such that the call rate gap narrowed and was eventually closed entirely. In addition to this change to the call market system, non- bank

<Table 15>          Daily Absolute Change in Interest Rates¹⁾

(percent)

Note:  1) Periodic average of the absolute change in interest rates. 

Source:  Korea Investors Service, KIS- LINE.

financial institutions were permitted to receive money from bank accounts, thus causing the call rate differential between banks and non- bank financial institutions to close as well.

The second quarter of every year is a time when firms generally increase their outlays for investment due to seasonal factors, but this year, the interest rates are 

- 49 -

expected to be stable due to the recession, declining inventories, the central bank's supplying of money to financial institutions, exchange rate stability, and the decline in the current account deficit. The CB yield, which is main indicator of market interest rates, will fluctuate around 12.2 percent within the range of 11.5 to 12.7 percent. It will change little from the first quarter. The interest rate differential between CDs and CPs versus CBs is expected narrow because of declines in both issuance of CDs and discounting of CPs. The call rate will remain at 11.0 percent, once again for the reason that the central bank has supplied ample amounts of cash.

Facility investment by firms is expected to increase by only 2.0 percent, but this will help lower interest rates. Some statistics indicate that the growth in facility investment by 200 specific industrial firms was actually 21.0 percent last year. Demand for working capital will also be low because the growth in inventories has slowed markedly. The CPI is expected to rise about 4.6 percent as government price

<Table 16>                   Interest Rate Forecast¹⁾

(percent)

Note: 1) The figures for the first quarter 1997 are estimates and those for the second quarter are forecasts.

Sources:  The Bank of Korea, Monthly Bulletin, various issues.

Korea Investors Service, KIS- LINE.

controls and the recession prevent public utility charges, wages, and service charges from rising steeply.

As earlier stated, the overseas sector has increasingly greater influence on domestic interest rates, for several reasons. The current account balance deficit peaked in February and is now falling, so Korean manufacturing firms' and financial 

- 50 -

institutions' credibility on the overseas market is beginning to recover from the shock of the Hanbo bankruptcy, and because Japanese banks will complete their settlements of accounts by the end of March, the volume of capital inflows should increase. Additional capital inflows will also be induced by the raising of the limit on aggregate foreign investment in the stock market by another three percentage points on May 1. These inflows will, in turn, help stabilize the Korean won, which itself will remain around the level of 900 to the dollar. All of these developments will work to pull interest rates down.

The psychological factors which forced interest rates up during the first quarter seemed to have lost their force by the end of March. Interest rates are therefore not

expected to rise as they did during the last quarter; that is, if there is no

<Table 17>                Firms' Shortage of Funds¹⁾

Note: 1) The figures are forecasts based on the KIF Flow of Funds model. Note that savings = current GNP -  net factor income from the rest of the world -  final consumption; Investment = Gross capital formation in the National Income Account. 

Sources: The Bank of Korea, The Flow of Funds Account, various issues.

The Bank of Korea, National Income Account, various issues.

unexpected shock such as the bankruptcy of another large business group. Over the next three years, if we expect 6- 7 percent GNP growth and 4- 5 percent inflation, the CB yield should be about 10- 12 percent. A temporary increase in money demand would raise the CB yield for a short period of time, but because firms have greatly 

- 51 -

cut back their investment outlays and the process of inventory adjustment is almost complete, no such surge in money demand is in the offing. As a result, the CB yield can be expected to fluctuate around 12.0 percent during the second quarter and then fall to 11.0 percent towards the end of the quarter.

There are still some lingering fears of financial crisis in April because the Hanbo Group's commercial debt amounts to more than 6 trillion won. It should be noted, however, that Hanbo is only required to pay an amount of less than 100 billion won over the four months from April to July, not in April only, so the financial markets will not be much affected, if at all. Tax payments in April will not raise interest rates because firms, financial institutions, and the government duly plan for tax bills well in advance.

- 52 -

Financial Market Developments

Banking

Deposit Market

At the end of the first quarter of 1997, total bank deposits including deposits in won, CDs, and bills based on commercial and trade papers rose 3.4 percent to 226.4 trillion won. This is a slower rate of growth than that of the previous quarter and was due to several factors. First, the inflow of funds from bank trust accounts, which had been induced by last year's reforms of the money- in- trust system, continued. These inflows should last through the middle of May, when most of the bank trust accounts opened before last May will mature. Second, the total volume of CD issuance decreased sharply as a reserve requirement was imposed on CDs on the 23rd of February. Third, as the won has depreciated against the US dollar, the volume of foreign deposits has greatly increased. In addition, the back- to- back bankruptcies of the Hanbo and Sammi groups in the first quarter naturally meant that those firms' deposits in banks declined. 

Demand deposits fell by 10.3 percent to 22.7 trillion won in the first quarter. This was a weak showing compared to that in the previous quarter. It can partially be explained by seasonal factors such as a rise in demand for money for the Lunar New Year's Day and payments for college tuition bills and corporate taxes. It is also true that at the close of each year, banks usually increase their balances of checking accounts to make themselves appear larger on paper. This kind of practice of course means a sharp decline in the volume of demand deposits during the first quarter of the next year.

Time and savings deposits had sharply increased in the previous quarter, and they grew moderately during the first quarter, amounting to 143.1 trillion won by the end of it. The growth resulted from the continuing inflow of funds from bank trust accounts. These inflows were actually accelerated by the banks' own 

53

aggressive marketing efforts to increase the volume of time and savings deposits. Banks promoted high yield accounts including mutual installment savings deposits, and the new tax- exempt long- term deposits were very popular and also attracted a large volume of funds. By the 20th of March, almost 4.6 trillion won had been induced into banks including bank trust accounts. However, the introduction of this new product made the workman's long- term savings and household preferential installment savings deposit account less attractive, so the increase in total deposits in won was not as steep as some may have expected.

The total volume of CD issuances declined by 27.1 trillion won or 13.2 percent from the previous quarter. This was due to the imposition of a reserve requirement on CDs on the 23rd of February. It is believed that CDs and bills 

<Table 1>                        Bank Deposits¹⁾

54

based on commercial and trade papers are not as profitable for banks as other instruments since their deposit rates are determined through negotiation with investors. With the new reserve requirement for CDs, banks made efforts to transfer funds from CDs to bills based on commercial and trade papers, and the abolishment of the issuance limit on bills based on commercial and trade papers accelerated the growth in the volume of them. In fact, the volume of bills based on trade papers doubled in the first quarter. 

By the end of the first quarter, the balance of foreign deposits had risen by 11.9 percent from the previous quarter, amounting to 21.3 trillion won. The volume of foreign deposits held by domestic residents rose sharply as many engaged in foreign exchange speculation. 

<Table 2>                 Time and Savings Deposits¹⁾

(billion won, percent)

55

During the second quarter of 1997, the volume of total bank deposits is forecast to grow 3.9 percent to 235.2 trillion won. The volume of demand deposits is forecast to rebound from the poor performance of the first quarter, while the volumes of short- term time and savings deposits and foreign deposits are expected to grow at roughly the same rates as before. CDs are expected to decrease sharply during the second quarter, while bills based on commercial and trade papers and long- term time and savings deposits are projected to rise modestly.

These forecasts are based on several expectations. First, the issuance of CDs will decline steadily due to the newly imposed reserve requirement. Secondly, there might be a large inflow and outflow of money between the financial institutions if the fourth stage of interest rate liberalization begins in the second quarter, and the growth in the volume of time and savings deposits will be accelerated if the new comprehensive tax system on financial income is put into effect. And since the value of won is expected to fall further in the second quarter, residents' foreign deposits will continue to grow at about the same rate as during the first quarter. 

<Table 3>        Interest Rates on Selected Bank Deposits¹⁾

(percent)

56

Loan Market

The total volume of bank credits including loans in won, loans in foreign currencies, and guarantees and acceptances stood at 269.5 trillion won at the end of the first quarter, an increase of 4.7 percent from the previous quarter. Despite the aftermath of the bankruptcies of the Hanbo and Sammi groups, this growth was mainly the result of the strong rise in loans in won, which represented 70 percent of total bank credits in the first quarter. The volume of guarantees and acceptances rebounded from a decline in the previous quarter, but the increase was weak.  The growth in loans in foreign currencies was very low because domestic banks had great difficulty in raising funds from overseas markets due to the bankruptcy of Hanbo.

No doubt, the Hanbo and Sammi bankruptcies sent shock waves throughout the 

<Table 4>                        Bank Loan¹⁾

(billion won, percent)

57

entire financial sector and even the economy at large. They caused banks to refrain from making loans to small and medium- sized firms because of the increasing risk of bankruptcies among them. This, in turn, resulted in an increase in household loans and greater investment in securities. The bankruptcies also caused some domestic banks to suddenly find themselves awash in bad loans, thus affecting their credit ratings in the international financial market, and the free- fall of the won against the dollar, also partly spurred by the bankruptcies, naturally discouraged firms from taking out foreign loans, forcing the total volume of foreign loans down sharply.

During the first quarter, the volume of bills discounted declined by 24.2 trillion won, a 1.8 percent decline from the previous quarter. Credit risk managers assumed a conservative posture in the wake of the Hanbo and Sammi bankruptcies, and the volume of small and medium- sized firms' bills discounted fell because the government lowered the limit on the volume of loans that could be made to 

58

individual firms in February, when it also reduced the reserve requirement on CDs. 

<Table 5>               Loans with Banking Funds¹⁾

(billion won, percent)

The volume rebounded slightly late in the quarter because the government then advised banks to begin discounting bills issued by small and medium- sized firms, 

59

but the rise was hardly sufficient to offset the earlier decline. 

The volume of overdrafts soared 38 percent during the first quarter to 10.7 trillion won. Except for some large conglomerate, most firms had difficulties in raising needed finances because of the Hanbo debacle. The volume of overdrafts increased dramatically as they are easily accessed for individuals.

General loans in the first quarter recorded sound growth of 7.5 percent, amounting to 97.5 trillion won. This sharp increase was partly attributable to seasonal factors such as the increasing demand for money for the Lunar New Year's Day and payments for college tuition bills and corporate taxes, and there was a greater number of buyers in the real estate market. An increase in household loans, which banks promoted aggressively in the first quarter, also contributed to the overall growth in general loans. 

The volume of loans in foreign currencies, largely used for firms' investment in equipment, is estimated to have reached 23.7 trillion won in the first quarter, a meager increase of only 3.0 percent increase the previous quarter. Once again, the Hanbo bankruptcy had a great part to do with this. As previously indicated, it caused banks to experience difficulties in raising funds in the international financial 

<Table 6>            Interest Rates on Selected Bank Loans¹⁾

(percent)

60

market. The other major factor was the depreciation of the won against the dollar, 

although that too was partly a result of Hanbo. Investment by firms had already been on the downturn for some time, but the depreciation of the won made loans in foreign currencies less attractive to borrowers. 

Guarantees and acceptances increased only by 1.1 percent in the first quarter. The government made efforts to alleviate the tightness in the financial market, but it was clearly fighting an uphill battle because the risks of bankruptcies among small and medium- sized had risen greatly. 

Based on the following expectations, the total volume of bank credits is forecast to rise 5.3 percent in the second quarter to 283.8 trillion won. The government and financial institutions have made efforts to stabilize the financial markets, so some of the tightness should be relieved, and the volume of loans to small and medium- sized firms is forecast to grow because the government is going out of its way to help them weather the recession. However, the volume of loans in foreign currencies is not likely to rebound since many domestic banks' credit ratings on the international financial market have suffered. 

Bank Trust Market

At the end of the first quarter, the total volume of trust accounts at deposit money banks is estimated to have risen to 157.2 trillion won, a 4.0 percent increase from the previous quarter. Despite the continuing outflow of funds from bank trusts owing to last year's bank trust reforms, the abolishment of general nonspecific trusts, and the lowering of the issuance limit on development trusts, the volume of money- in- trusts had continued to increase from the previous quarter due to a strong showing for specific trusts, specific purpose installment trusts, and tax- exempt household trusts. However, the balances of trust accounts at those banks which are most greatly affected by the Hanbo debacle, declined, while those at other banks increased. More specifically, there was a sudden outflow of funds from 

61

bank trust accounts at the former into time and savings deposits or trust accounts at the latter.

The total volume of household trusts recorded a 1.8 percent decline during the first quarter.  The yields on these trusts have been declining as the market interest rates have edged downwards, thus making them less attractive. Although the government tried to reduce the volume of trusts with fixed returns, including general nonspecific trusts, nonspecific trusts increased in the first quarter as banks made special efforts to promote specific purpose installment trusts. 

The volume of specific trusts showed sound growth in the first quarter, 

<Table 7>                      Trust Accounts¹⁾

(billion won, percent)

62

reaching 33.6 trillion won. The rates of return on specific trusts are determined by the rates of return on the investments that are specified by the trust investors. As 

the short- term interest rates were high in the first quarter, institutional investors including insurance companies invested in banks' specific trusts. The volume of tax- exempt household trusts, introduced in the previous quarter, sharply increased, 

reaching 2.2 trillion won in the first quarter. Personal pension trusts on the other hand, declined because individual investors found them to be less attractive compared to the tax- exempt household trusts.

63

The volume of money- in- trusts is expected to rise 1.7 percent to 159.8 trillion won. This is a slightly lower rate than that recorded in the previous quarter, and this forecast is based on several factors. It is expected that general nonspecific trusts offering fixed returns will be abolished, and the issuance limit on development trusts, of which the returns are also fixed, will be reduced. Although the outflow of funds from trust accounts induced by the bank trust reforms is expected to continue, the growth rates of household, corporate, and retirement 

pension trusts are forecast to increase since the rates of return on them are expected to be relatively high. The market interest rates are forecast to fall in the second quarter, and the rates of returns on those trusts are fixed according to the previous contracts, which mostly specify high yields. The highly popular tax- exempt household trusts will also continue to induce funds into banks as well. 

<Table 8>   Loans Funded by Bank Trusts and Investment in Securities¹⁾

(billion won, percent)

64

Non- bank Financial Institutions

Overview

In the first quarter of 1997, total deposits at non- bank financial institutions (NBFIs) grew slightly faster than during the previous quarter, rising at a 5.8 percent rate. During the first quarter of 1997, own paper issuance and the volume of CMAs at Merchant Bank Corporations (MBCs) rose steeply, even though commercial paper sales at MBCs were slightly off. Total deposits at Investment and Trust Companies (ITCs) bounced back from the 1.0 percent decline in the fourth quarter of 1996 and grew 5.7 percent because bond funds and the new MMFs have become more attractive to investors. Mutual Savings and Finance Companies (MSFCs) continued to experience anemic growth in total deposits because the differential in interest rates between their products and those offered by banks has narrowed. Total deposits at Mutual Credits (MCs) and Community Credit Corporations (CCCs) rose at roughly the same rate as during the previous quarter.

The rate of growth in total credits at NBFIs changed little from the fourth quarter of 1996. During the first quarter, NBFIs were very conservative in their lending to small and medium- sized firms in the wake of the bankruptcies of the Hanbo and Sammi groups. Paper discounts related to trade bills and the volume of factoring by MBCs fell sharply due to the slowdown in exports and low domestic sales of goods, respectively. However, many firms increased their issuance of commercial paper in order to satisfy their working capital needs because of the low investor demand for corporate bonds and stocks.  Total credits at regional financial institutions such as MSFCs and MCs showed sluggish growth since they were also very concerned about the increasing default risks of small and medium- sized firms.

In the second quarter, total deposits at NBFIs are expected to grow at a slightly lower rate than during the first quarter. Even though own issuance of paper and the volume of CMAs at MBCs are expected to show fairly high growth rates, a sharp 

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<Table 9>                Deposits and Credits at NBFIs¹⁾

(billion won, percent)

Notes:1)End of period.  The figures in parentheses are percentage changes from the previous quarter.

      2) Deposits at non- bank financial institutions = Merchant Bank Companies (issuance of     their own papers + CMAs + sales of bills) + Investment and Trust companies        (beneficiary certificates + stock savings) + Mutual Savings and Finance Companies 

(deposits) + Mutual Credits (deposits) + Postal Savings (deposits + RP).

3)Credits at non- bank financial institutions = Merchant Banking Corporations (paper 

discounts) + Mutual savings and Finance Companies (loan + paper discounts) + 

Mutual Credits (loans) + Credit Unions (loans) + Community Credit Cooperatives (loans).

4) Estimates. 

5) KIF Forecasts.

Sources:The Bank of Korea, Association of Merchant Banking Corporations, Association of Mutual 

- 66 -

Savings and Finance Companies, and Association of Credit Unions, Korea Credit Rating Agency.

decline in commercial paper sales will drag down the growth of total deposits at MBCs. The stock market will likely remain stagnant, and total deposits at ITCs are expected to grow at about the same rate as during the first quarter due to strong sales of bonds funds and MMFs. Though regional financial institutions such as MSFCs and MCs are expected to pursue M&As with nearby financially distressed institutions for the purpose of restructuring, the narrowing differential in interest rates between banks and regional financial institutions will likely prevent total deposits at MSFCs and MCs from growing at a higher rate than during the first quarter.

NBFIs should see slow growth in total credits in the second quarter. Most NBFIs are expected to be very cautious in making loans to small and medium- sized firms, even to fairly large firms. MBCs will witness a decline in paper discounting related to trade bills and a lower volume of factoring. The regional financial institutions such as MSFCs and MCs will try to make more loans to households rather than small and medium- sized firms, whose default risks are expected to be far higher than those of the former, but this will only marginally increase the growth rate of credits if at all. 

Merchant Bank Corporations

The balances of CMAs rose sharply in the first quarter because investors were attracted by the rise in short- term interest rates, which occurred due to the turmoil in the short- term money market, and issuance of own paper increased by 12.5 percent, mainly because of simplification of procedures. Nevertheless, total deposits at merchant banks grew at a slightly lower rate than during the previous quarter because of slower growth in sales of bills. Sales of bills constitute the largest percentage of deposits at merchant banks, but they did not increase appreciably compared to the previous quarter. The demand for commercial paper by institutional investors, most notably bank trusts, has been falling since the money- in- trusts system was reformed last May, and commercial papers with face values of less than or equal to ten million won, on which yields are fixed by the law, became less and less attractive in March as the 

- 67 -

real market rates of interest on other types of investments were rising.

Total credits at MBCs during the first quarter grew 9.7 percent, slightly more faster than during the previous quarter, due to the increased volume of discounting of commercial paper. In March, the Hanbo group declared bankruptcy. This was a most sensational event which shook the financial sector to its foundations. The short- term money market was the most adversely affected, so short- term interest rates soared. Amidst the tremendous uncertainties that the Hanbo collapse created, many firms increased their issuance of commercial papers for fear of not being able to raise needed capital later on. This inevitably brought about the increase in discounting of commercial paper by MBCs. However, the volume of paper discounting related to trade bills fell sharply because exports remained sluggish, and the volume of paper discounting by factoring fell as merchant banks had little incentive to extend credits to small and medium- sized firms. It is also true that an increasing number of other finance companies have been expanding their factoring operations and are therefore encroaching on MBCs' market shares.

<Table 10>               Deposits and Credits at MBCs¹⁾

(billion won, percent)

Notes:  1)End of period. The figures in parentheses are percentage changes from the previous quarter.

2) Estimates.

- 68 -

Source:  The Association of Merchant Bank Corporations.

In the second quarter, total deposits at merchant banks are expected to grow slowly. The volume of own paper issuances and the balances of CMAs, especially the new CMAs with substantially higher yields, are expected to increase sharply, but sales of commercial paper will still fall slightly as an increasing number of firms declare bankruptcy.

Total credits at merchant banks will experience substantially slower growth, too. The volume of paper discounting related to trade bills and factoring are expected to continue declining due to sluggish exports and domestic sales. The MBCs will, in general, not engage themselves heavily in paper discounting, and most nonbank financial institutions are expected to take a very conservative stance on lending to small and medium- sized firms. In April, securities companies will be allowed to engage in brokering of CP. There are widespread fears that MBCs may lose much of their market shares as a result, but it should be pointed out that the securities companies will not in fact pose a major threat because they have not been permitted to engage in discounting of CP. Many MBCs, especially those which were transformed 

from IFCs last year, will attempt to diversify into international finance and leasing

<Figure 1>               Deposits and Credits of MBCs

- 69 -

services. However, they do not seem to have executive staff who are experienced in these areas, and they will have great difficulties in finding suitable business partners abroad.

Investment and Trust Companies

While the volume of long- term bond funds increased slightly over the last quarter, the volume of short- term bond funds such as MMFs increased steadily due to the rise in short- term interest rates. Slight increases in the balance of the stock funds indicate that small investors widely expect a recovery of the stock market. As a result, the total balance of funds at ITCs was an estimated 72 trillion in the first quarter, an increase of 5.4 percent from the previous quarter.

Until the middle of the first quarter, the ITCs had been selling stocks, but they 

<Table 11>                    Deposits at ITCs¹⁾

(billion won, percent)

Notes:  1) The figure in brackets are percentage weights, and the figures in parentheses are percentage changes from the previous quarter.

Notes :  2) Forecasts. 

Notes :  3) Sold since September 6, 1996.

Source:  Korea Investors, Inc., ｢KIS- LINE｣.

- 70 -

finally began buying towards the end of the quarter. In managing their bond funds, on 

the other hand, they preferred bluechip bonds to bonds issued by small and medium- sized firms, and for the entire quarter, they bought slightly more bonds than they sold.

The three large Seoul- based ITCs were allowed to increase their capital. Through 

financial restructuring, they were able to use some of the new capital to purchase stocks. The newly established ITCs were permitted by the government to reduce the 

ratio of stocks in their funds from 50 percent to 20 percent, so they had more room to diversify their portfolios.

In the second quarter, the balances of both bond funds and stock funds at ITCs 

are likely to increase steadily. As the stock market reverses itself and rebounds gradually, it will encourage fund managers to put more money into stock portfolios. Anticipating stability in the market interest rates in the second quarter, bond fund managers are expected to invest some shares of their funds, which would otherwise have gone into CPs and CDs, in mid and long- term corporate bonds.

<Table 12>                    Investment by ITCs¹⁾

(billion won, percent)

Notes:  1) End of Period. The figure in brackets are percentage weights, and the figures in parentheses are percentage changes from the previous quarter.

Notes  : 2) Estimates.

Notes  : 3) Forecasts.

Source:  The Bank of Korea.

- 71 -

Mutual Savings and Finance Companies

As was the case for other non- bank financial institutions, total deposits at MSFCs grew slowly in the first quarter. There were declines in the volume of demand deposits, installment savings, and long- term time deposits for workers whereas time deposits with compound interest and tax- exempt savings accounts showed modest growth. The slow growth in total deposits at MSFCs for the last several quarters can be attributed to the narrowing interest rate differential between banks and MSFCs and the fact the recurrent financial failures among MSFCs have given them a bad name in the opinions of some investors.

Total credits at MSFCs grew at much the same rate as during the previous quarter. The volume of loans to households increased modestly, but the volume of loans to small and medium- sized firms and the volume of discounting of commercial paper fell as MSFCs' decided to take a conservative stance in their financial management in order to weather the considerable financial uncertainties of the first quarter.

MSFCs are expected to experience a slightly lower rate of growth in deposits in the second quarter than in the first quarter. The competition for retail banking among financial institutions will become fierce, and the interest rate differential between banks and MSFCs will narrow further in the second quarter. Several MSFCs are expected to merge with others for purposes of restructuring, and those merged MSFCs will be allowed to open new branches. However, these mergers are expected to have only marginal effect with regard to increasing deposits.

In the second quarter, total deposits at MSFCs are expected to remain at about same level as in the first quarter. Due to the continued recession, MSFCs will have hard time finding suitable clients for discounting of commercial paper. They will therefore maintain a conservative stance on making loans to small and medium- sized firms and put more emphasis on extending loans to households. 

- 72 -

<Table 13>                  Deposits at MSFCs¹⁾

(billion won, percent) 

Notes: 1)End of Period. The figures in parentheses are percentage changes from the previous quarter.

 2) Estimates.

 3) KIF Forecasts.

Source:  The Association of Mutual Savings and Finance Companies. 

<Figure 2>          Deposits and Credits at MSFCs

- 73 -

Financial Institutions Specialized in Lending 

There was a great deal of debate in the first quarter about ways in which several laws regarding financial institutions specialized in lending, such as leasing companies, credit card companies, and consumer finance companies, should be integrated and how those companies should be restructured. In the interests of the stability of the financial sector, the Presidential Committee on Financial Reform recommended that leasing companies and installment finance companies be granted licenses as long as they meet several requirements, including minimum capital requirements, whereas credit card companies should be subject to more stringent licensing requirements and be approved by the Ministry of Finance and Economy. Many financial institutions which have separate leasing, credit card, and installment finance subsidiaries are expected to merge them into single entities. Furthermore, several conglomerates and department stores are known to be highly interested in establishing their own lending operations, so the competition among institutions specialized in lending will certainly be more severe in the near future.

<Table 14>                 Credits at MSFCs¹⁾

(billion won, percent)

Notes: 1)End of period. The figures in parentheses are percentage changes from the previous quarter.

 2) Estimates.

 3) KIF Forecasts.

Source:  The Association of Mutual Savings and Finance Companies. 

- 74 -

In the first quarter, the credit card industry showed remarkable growth. Corporate customers made heavy use of their cards, and the credit card companies embarked on a major promotion campaign. Last year, the Ministry of Finance and Economy proposed some changes for the credit card industry. It called for more stringent standards for credit card issuance, introduction of a referral system for multiple card holders, establishment of an integrated merchant- issuer payment system so that merchants would only have to contract one issuer at time of sale. Some of these changes have already been made, and some of them, such as the ones concerning the referral system and merchant- issuer payment system, have been postponed until issuers establish appropriate computer systems and reach agreement on the rules for charging commission. In the near future, many foreign institutions as well as domestic institutions are expected to enter the market for credit cards, so the existing credit card companies will be obligated to improve their efficiency in order to survive.

According to the financial statements of installment finance companies for the last fiscal year, financial subsidiaries of manufacturers turned in far superior business performances than finance companies which are subsidiaries of financial institutions. The former had an advantage in installment financing because it was their parent companies which produce the electronic goods and automobiles for which their financing was required. The latter had no choice but to concentrate on paper discounting and factoring.

In the first quarter, installment finance companies had difficulties in raising funds through issuance of bonds and borrowing. To make the matter worse, the rise in market interests in March caused their funding costs to explode, resulting in even negative real funding and lending rate differentials in some cases. The business prospects for installment finance companies in the second quarter are not bright, especially with regard to factoring.

Leasing companies have played a unique role in providing funds for long- term capital investment throughout Korea's economic development. In the past, the leasing market had been rather oligopolistic, so leasing companies had experienced tremendous growth of 10~40 percent every year. Last year, however, leasing companies saw their 

- 75 -

leasing activity drop off slightly because the current economic recession reduced firms' demand for long- term capital investment. More importantly, however, the leasing market became more competitive last year after all 15 of the investment and finance companies were converted into merchant banks, which can engage in leasing. As firms will prefer to raise funds through the primary financial market and the economy shows no sign of recovery, the business environment for leasing companies will not be good in the second quarter.

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Money and Capital Markets

Stock Market

Despite the government's efforts to boost the economy, the stock market turned in yet another lackluster performance in the first quarter of 1997. The Korean Composite Stock Price Index (KOSPI) fell from 659.44 at the beginning of the quarter, bottomed out at 610, and then recovered to 670 by the end of the quarter. There were several developments which affected the already sluggish Korean stock market for the worse: the labor union strike against the amendments to the labor law, the bankruptcies of the Hanbo and Sammi groups (Korean conglomerates), increases in interest rates, and the free fall of the won against the U.S. dollar, which itself was caused by the soaring current account deficit.

Stock prices and interest rates moved in opposite directions in the first quarter. This could be partly explained by the behavior of institutional and foreign investors. Because of the economic situation as described above, particularly the financial market distress which occurred in the wake of the successive defaults of the Hanbo and Sammi groups and the expectations of tight monetary policy, institutional and foreign investors employed very defensive strategies in their investment. They sold off large 

volumes of stocks and purchased short- term financial instruments. This of course made

<Figure 3>        KOSPI and Customer Deposits

- 77 -

the stock market even more stagnant.

Although the average trading volume during the quarter was decreased by 12.62 percent compared to the same quarter of last year, there were steady increases in customer deposits and slight declines in credit loans outstanding. Many individual investors held on to their stocks in anticipation of a rise because the government would take actions in an attempt to stimulate the market.

About 352 billion won worth of new stock was issued through initial public offerings and rights offerings by listed companies during the quarter, which was approximately 36 percent of the volume of new stocks issued during the same quarter of last year. The overall economic slowdown clearly dampened firms' demand for funds for equipment investment, and the government had imposed new restrictions on new stock issuances in order to maintain market stability. 

Individual investors, insurance companies, and foreign investors all recorded net purchases of stocks during the quarter while investment and trust companies (ITCs), banks, and securities companies recorded net sales. More specifically, banks, securities companies and ITCs recorded net total sales of 305.9 billion won, 189 billion won, 

and 142.2 billion, respectively, as they adjusted to the continuing decline in stock 

<Table 15>KOSPI, Trading Volume, and Fund Flows¹⁾

(billion won, thousand shares, percent)

Notes:  1) The figures in parentheses are percentage changes from the previous period.

2) End of period. Firms with negative profits are excluded.

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Source:  Korea Stock Exchange. 

prices. Foreign investors recorded net purchases at the beginning of the quarter but then began recording net sales during the mid- quarter due to the economic recession

and the instability in the foreign exchange market, although these sales were outweighed by their earlier purchases. 

There were two major institutional changes in the stock market in the first quarter: the introduction of the stock options system and the experimental market for stock index options. Both are expected to significantly facilitate the functioning of the stock market. The stock index options market, which will begin full operation this coming July, should help investors hedge against stock price fluctuations and encourage them to lengthen their investment horizons. The options market, for example, will allow investors to link stock index options to stock index and stock 

<Table 16>              Stock Offerings and Credit Loans 

(billion won)

Note:  1) End of period.

Source:  Korea Securities Supervisory Board.

<Table 17>         Investors' Stock Trading (Cumulative Net Sales)

(billion won)

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Source:  Korea Securities Supervisory Board. 

index futures.  Both stock index options and stock index futures will prevent investors 

from manipulating stock prices, thus contributing to the efficiency and autonomy of the market.

In the second quarter, the stock market is likely to show some improvement. According to the average forecast by market watchers, the KOSPI should rise to around the 710 point level, about a 45 point rise from the first quarter. There are several factors which should help the stock market during this time. Institutional investors will likely invest their excess funds into the stock market because interest rates are expected to remain low, and there will be an inflow of 700 billion to 1 trillion won worth of new capital from abroad after the the ceiling on foreigners' aggregate stock holdings is raised from 20 percent to 23 percent on May 1. However, there are also some factors that may prevent the stock market from fully recovering. The U.S. dollar is expected to continue rising in the foreign exchange market during the second quarter, and the increase in uncertainties due to the Hanbo and Sammi bankruptcies may prevent many investors from participating actively in the stock market. Overall, demand should exceed supply to some degree, helping the stock market to inch upwards. 

Like the first quarter, there will be important institutional changes in the stock market in the second quarter. The recent amendments to the Securities Exchange Act will go into effect so that securities companies may operate more freely by virtue of the lowering of entry barriers to the market and the improved open- market operations. Securities companies will also begin trading in CPs and brokering, so they will hopefully be more profitable. Finally, in order to prevent investors from being exposed to the risks of bankruptcy or insolvency of securities companies and to improve the safety and stability of the securities industry, a "risk management system based upon own capital" will be introduced.

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<Table 18>       Foreign Investment in the Korea Stock Exchange 

(billion won) 

Source:  Korea Securities Supervisory Board.

Bond Market

Both short- term and long- term interest rates were highly volatile during the first quarter of 1997. The average yield on corporate bonds rose from 12.28 percent in the previous quarter to 12.32 percent. In the beginning of the first quarter, the corporate bond yield was driven down to 11.85 percent due to the aggressive purchasing of bonds by institutional investors, but by the end of March, the yield rose back to 13 percent. The rise in the interest rate was due to the instability of the short- term capital market, sparked by the back- to- back bankruptcies of the Hanbo and Sammi groups, the depreciation of the won against the U.S. dollar, and cash- flow difficulties at financial institutions.

Banks preferred short and mid- term financial instruments like CDs and CPs to 

long- term corporate bonds as they were concerned about possible financial market 

<Table 19>                    KOSPI Performance

(billion won, point)

Note:  1) KIF Forecasts.

Source:  Korea Securities Supervisory Board.

<Figure 4>                    Bond Yields

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