Lead- Lag Relationships between 

KOSPI200 Index and Index Futures

Keehong Bae* and Baekin Cha**

I. Introduction

On May 3, 1996, the Korean Stock Exchange launched its first derivative product, the KOSPI200 index futures.  A futures contract is an agreement to buy or sell a specific product (underlying asset) at a specific price at a specific time in the future. The underlying asset of the futures contract can be a traded good or a non- traded good such as inflation rate.  Index futures is a contact whose underlying asset is a stock price index.  The essence of the index futures contract is to bet on the future price movement of the underlying index.  That is, futures traders would take a 'long position,' if they expect the index price to increase in the future and a 'short position' otherwise. Future gains or losses would, of course, depend on whether their expectations are correct ex post. 

Although the nature of the futures market is highly speculative, it provides such important functions as hedging and price discovery.  This paper examines the role of index futures as a vehicle for price discovery.  The index futures price reflects the expectations of market participants on the future price of the index and accordingly provides information on the expected future price.  Information on expected future price aids the decision- making of market participants and thus enhances the efficiency of the market in general.

Previous literature that has examined the relationship between the stock index and index futures of developed markets shows that the futures market leads the spot 

*  Assistant Professor, Department of Economics and Finance, City University of Hong Kong 

** Research Fellow at the Korea Institute of Finance 

market.  This indicates that futures price provides the information on the expected future price and plays the role of the price discovery vehicle.  The futures market as a price discovery vehicle, paradoxically, means that the market is incomplete.  In a complete market in the absence of transaction costs and information asymmetry, index futures price and underlying index would exhibit a complete contemporaneous correlation and no cross- correlation would be observed.  In other words, a lead- lag relationship between index futures price and spot index does not exist in a complete market..  A lead- lag relation is due to the market friction such as the non- synchronous trading among the index component stocks, the liquidity difference between the futures and spot markets, high transaction costs, capital requirement, short- selling restrictions, etc.

This study analyzes the lead- lag relationship between KOSPI200 index and index futures price and evaluates the role of KOSPI200 index futures as a price discovery vehicle.  We examine the price linkage between spot index and index futures using a vector autoregression (VAR) with no priori restrictions.  Empirical results show that new information is reflected in the futures price first and spilled over to the spot market..  While the analysis of the Granger causality reveals the bilateral causal relationship, the significance level of futures price Granger- causing the spot price is much higher than that of the opposite direction.  The analysis of impulse response function indicates that the impact of the futures shock on the spot is much larger and more persistent than the impact of the spot shock on the futures.  This asymmetric behavior response suggests that new information is reflected into the futures market first and the spillover of the information from the futures market to the spot market is quite slow.  The sluggish response of the spot market to the new information is thought to be due to the market friction in the spot market such as the short- selling restriction, high transaction costs, etc., which makes the swift execution of transaction incorporating new information difficult.

The rest of the paper proceeds as follows.  Section 2 discusses the theoretical background of the price linkage between the spot index and index futures and previous findings.  Section 3 describes the data used and empirical methods and presents the results.  Section 4 concludes.

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II. Theoretical Discussion

1. Spot Index and Index Futures

With no transaction costs and non- stochastic interest rates and dividend yields, futures price can be determined in the cost- of- carry model as follows

or

Equation (2) implies that i) the variance of the rate of return of the index futures is the same as the variance of the rate of return of the spot index; ii) the returns of index futures is completely contemporaneously correlated with the returns of spot index; and iii) cross- correlation between two index returns is zero.  This indicates, in turn, that in the complete market the lead- lag relationship between the spot index and index futures does not exist.  In reality, however, there are several market imperfections that may cause the lead- lag relation.

First, the lead- lag relationship may be caused by the non- synchronous trading of index component stocks.  For instance, if some of the index component stocks are not transacted at the time T the index value is computed, the new index value is based on the last transaction prices (say at time T- 1) that do not incorporate the new information into the new index value.  That is, the new index value has the stale 

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price problem.  Given that the index futures price does not have the stale price problem, one would conclude that the spot index lags the index futures.

Second, the lead- lag relationship may be caused by the difference of liquidity between two markets.  For instance, if the average transaction time of index component stocks is longer than the average transaction time of the index futures contract, it is likely that futures market more speedily incorporates the new information into the price, which results in the lead- lag relationship.  In this case, what causes the lead- lag relationship is not the absolute liquidity difference but the relative difference.

Lastly, Stoll and Whaley (1990) and Miller (1990) argue that it is more advantageous to trade in the futures market rather than in the spot market due to the incompleteness of the market such as the high transaction costs, capital requirement, and short- selling restrictions.  In particular, traders with monopoly information is more likely to employ futures market since it has lower transaction cost and execution of the transaction is easier.  When traders of this kind are abundant in the market, the futures leads the spot.  Subrahmanyam (1991) and Chan (1992) argue, on the other hand, that when informed traders have firm- specific information rather than market- wide information, it is more profitable to trade specific stocks directly in the spot market instead of using index futures.  In this case, the information flow is from the spot market to the futures market.

2. Previous Literature

The general conclusion of the studies investigating the relationship between futures and its underlying assets is that the index futures leads the spot index.  Ng (1987) examines the stock index, exchange rates and commodity prices, and concludes that futures price Granger cause the spot price and the futures leads the spot in incorporating the new information.  Kawaller, Koch and Koch (1987) report that S&P 500 index futures price leads the S&P 500 index by 20 to 45 minutes, while the spot index leads the futures price at most by one minute.  Stoll and Whaley (1990) report that S&P 500 index futures price and Major Market Index futures price tend to lead underlying index by five minutes on average.

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Chan (1992) finds that futures price leads the spot price using the measure of market- wideness.  He also finds that spot index leads the futures price and this lead- lag relationship does not change with the different market conditions. Grunbicher, Longstaff and Schwartz (1994) examine the DAX index futures of the German market.  Iihara, Kato and Tokumaga (1996) examine the Nikkei Stock Average (NSA) index and its futures contract and argue that the futures strongly leads the spot index.

III. Empirical Results

1. Data

The data employed in this study contain the minute- by- minute intraday price series of KOSPI200 index and index futures contracts.  They cover the period from May 3, 1996 to November 26, 1996 and are obtained from the Korean Stock Exchange. KOSPI200 index is a value- weighted price series of 200 representative stocks traded in the KSE and its base date is January 3, 1990.

The settlement month of futures contract is March, June, September and December.  The maximum trading period of each contract is one year.  Accordingly, in April there are four futures contracts traded whose settlement month includes June, September, December and March of the following year.  This study employs the nearest- month contract to generate the futures price series.  During the sample period, the stock market opens 9:30A.M.- 11:30A.M. and 13:30P.M.- 15:00P.M., while the futures market opens 9:30A.M.- 11:30A.M. and 13:30P.M.- 15:15P.M.  To synchronize the time- series of two markets, the data in the last 15 minutes of the futures market are excluded in our study.

The last transaction price in the five- minute interval is employed to compute the intraday returns.  Rates of returns are computed as the log difference of price series. If there is no transaction price in the five- minute interval, the previous transaction 

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price is used.  The overnight returns are excluded from the sample.  The total sample size consists of 7,226 five- minute intraday returns over 169 trading days.

2. The Lead- Lag Relationship: A Preliminary Analysis

Table 1 presents some descriptive statistics of the returns series.  Over the total sample period, the average returns of the spot and the futures are - 0.0041% and - 0.0040%, respectively, suggesting that the market was on the downward trend. Notable is the lower average return of futures than the average return of the spot for the September futures contract, which indicates that the futures price is lower than the spot price.  As shown in Figure 1, the futures price of the September contract is well below the spot price and this phenomenon suggests that the theoretical futures price deviates quite significantly from the realized futures price in the market.  When the theoretical futures price is above the real futures price, index arbitrageurs can earn arbitrage profits by taking a long position in the futures market while taking a short position in the cash market.  In practice, however, it is almost impossible to make arbitrage profits since short- selling underlying stocks is extremely difficult in the Korean Stock Exchange 

Table 2 shows the autocorrelation patterns.  The first- order return autocorrelation of the futures and the spot index are 0.14 and 0.42, respectively, which are both significant at the 1% level.  This result contrasts with the results of Chan (1992) and Stoll and Whaley (1990) that S&P500 index futures has a small negative autocorrelation.  The index futures of the Korean Stock Exchange lacks liquidity relative to the US market and is more likely to be subject to the stale price problem. The spot market shows a higher degree of autocorrelation than the futures market, which is due to the non- synchronous trading of index component stocks as well as the stale price problem.

The following regression model is estimated as a preliminary analysis of the lead- lag relationship between the spot and the futures markets.

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Regression equation (3) examines the lead- lag relation of the first moment of returns and ignores that of the second moment of returns.  Recent studies (French, Schwert and Stambaugh (1987), Seguin (1990), etc.) show that the variance of returns is time- varying.  Using the bivariate GARCH model, Chan, Chan and Karolyi (1991) find that the volatility of the futures and the spot markets affects each other.  Given the previous literature, the error term in equation (3) does not satisfy the assumptions of traditional regression model.  Therefore, this paper examines the statistical significance using the t- statistics of Newey and West (1987).  The Newey and West t- statistics have the advantage of providing consistent estimates even in the presence of autocorrelation and heteroskedasticity.

Table 3 presents the regression results.  Contemporaneous correlation coefficients are 0.32 for the whole sample period, 0.49 for June contract, 0.26 for September contract, and 0.36 for December contract.  The estimates of the lag coefficients are all significantly positive at the 1% level.  While the estimates of lead coefficients are significantly positive, the magnitude of the coefficients is relatively small and so is the size of t- statistics.  Overall, the regression analysis appear to support that the futures market leads the spot market.

3. Vector Autoregression Model

Here, using the vector autoregression (VAR) model, we attempt to provide further empirical evidence on the relationships between the rates of return of index futures 

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and spot index.

In general, a q- th order vector autoregression (VAR) model for an N×1 column vector X is written in the form of the following regression equation:

A. Block Exogeneity Test

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Using the X vector in equation (6), the VAR model was estimated at four levels, that is, for the June; for the Sept.; for the Dec.; for the total index contract sample. In each estimation, the constant vector was used as deterministic factor H. As we use different samples for different settlement months, the number of lags was not equal across samples.  We found that little was gained by allowing for longer than nine lags for the June, six lags for the Sept., eight lags for the Dec., and eleven lags for the total index contract sample, respectively.  These lag lengths were determined by the Akaike Information Criterion(AIC). 

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Table 4 presents the results of the test for Granger causality between two rates of return.  The results show that the causal relationship is bilateral at the 1% significance level. This also shows that taking account of the past values of the other variable as well as those of own variable leads to improved predictions for the variable in concern. 

B. Impulse Response Analysis

The impulse response function is the most important part in the VAR analysis which shows how each of variable responds in dynamic ways to shocks in any of the other variables when there is no additional shock.  The investigation of the patterns of impulse response functions reveals not only the differences between responses of variables but also the ordering of the causality relationships between variables.  For example, if index futures leads spot index, the responses of spot index to a shock in 

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index futures will be large in magnitude.  But, since the information of shocks of the rates of return of the spot index has already been reflected in the index futures, the effects on the index futures of shocks in the spot index will be much smaller in magnitude. 

The effects on the rates of return of the spot index of a shock in the rates of return of the index futures are much larger.  Based on the total sample, a 1% increase in the rate of return of the index futures caused the rate of return of the spot index  to increase and the peak effect of a 0.33% increase appeared after five minutes.  The response after the peak did not quickly dampen out, and the growth of rate declined slowly through time. For the rates of return of the spot index, the effects of the shock died out completely about 45 minutes. Meanwhile, to a 1% shock in the rate of return of the spot index, the rate of return of the index futures increases by 0.114% at maximum, but such an effect dampened out quickly, and then declined and recovered alternately.

The above results indicate that the speed at which the spot market proceeds information to the futures market is relatively slower. These results  seem to come from the fact that quick trading is deterred by the inefficiency of the spot market such as high transactions cost, the limitation of lender, etc.

The contrasted systematic patterns of the responses in the total sample also appeared in the June, September, and December contract samples, respectively.  The increases of the rates of return of the spot index to a 1% shock in the index futures peaked of 0.492%, 0.268%, and 0.366%, respectively.  The maximum effect appeared in the case of the June contract sample.  The periods of time over which the response of the rate of return of the spot index dampen out appeared to be similiar to the case of the total sample. The increases of the rates of the return of the index futures  to a 1% shock in the spot index all peaked after ten minutes with the size of  0.064%, 0.138%, and 0.124%, respectively. The minimum effect appeared in the case of the June contract sample. 

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Overall, the impulse response analysis shows that effects on the spot index of a shock in the index futures are much larger in magnitude and that such effects persist for longer time than the reverse case.

Ⅳ. Conclusions

This paper examined the price linkage between the KOSPI200 spot index and the KOSPI200 index futures based on 5 minutes returns for the periods from May 3, 1996 to November 26, 1996.  The focus of our analysis is on the price discovery function of the future market for future stock prices in that the index futures prices provide the information about the predicted value for future stock prices and reflect the anticipation of market participants for them.  New information about the predicted values for future stock prices can be another benchmark for the decision making for economic activity and make the functioning of the entire economy more efficient.

The results of our empirical analysis indicate that the rates of return of the index futures lead those of the spot index and new information is reflected more quickly in the futures market than in the spot market. Probably these results come from the fact that the inefficiency of the spot market such as high transaction costs, the limitation of lender, etc. makes more attractive for the traders with new information to use the futures market where transaction costs are low and futures contracts can be traded swiftly.  The results also indicate that the speed at which the  spot market proceeds new information is slower, and the market friction in the spot market is relatively bigger than in the futures market.

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Kawaller, I. G., P.D. Koch, and T. W. Koch, 1987, The Temporal Price Relationship between S&P Futures and the S&P Futures Index, Journal of Finance Vol.14, 373- 397.

Miller, M. H., 1990, International Competitiveness of U.S. Futures Exchanges, Journal of Financial Services Research Vol.4, 387- 408.

Newey, W. K. and Kenneth D. West, 1987, A Simple, Positive Semi- Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix, Econometrica Vol.55, 703- 708.

Schwert, W., and P. Seguin, 1990, Heteroskedasticity in Stock Returns, Journal of  Finance Vol.45, 1129- 1156.

- 13 -

Sims, C. A. 1972, Money, Income and Causality, American Economic Review Vol.62, 540- 552

Sims, C. A. 1980, Macroeconomics and Reality, Econometrica Vol.37, 1- 49

Stoll, H. R., and R. E. Whaley, 1990, The Dynamics of Stock Index and Stock Index Futures Returns, Journal of Financial and Quantitative Analysis Vol.25, 441- 468.

Subrahmanyam, A., 1991, A Theory of Trading in Stock Index Futures, Review of Financial Studies Vol.4, 17- 71.

- 14 -

<Table 1>  Summary Statistics

- 15 -

<Table 2>    Autocorrelation

Note: * indicates that the null hypothesis of zero coefficient is rejected at the 1% significance level.

- 16 -

<Table 3>           Regression Coefficients 

Note: * indicates that the null hypothesis of zero coefficient is rejected at the 1% significance level.

- 17 -

<Table 4>    Tests of Granger Causality 

Note: The F statistic is for the null hypothesis that the former variable does not Granger cause the latter variable.

- 18 -

<Figure 1>   Trends of KOSPI200 Futures Index and Spot Index 

- 19 -

<Figure 2>         Dynamic Impulse Response Functions

- 20 -

Macroeconomic Developments

Current Status and Prospects

Economic Growth 

Economic growth in Korea for 1997 is estimated at about 6.0 percent, which represents a further slowdown from the year before.  Exports boomed in the second half, but had little effect on GDP growth because equipment investment was down by 7.9 percent and private consumption grew only 4.3 percent.  The deficit in the current account balance narrowed to 8.9 billion dollars, down by a tremendous margin of 62.5 percent from 1996.  The prices of imported goods spiked at the very end of the year, but annual inflation, as measured by the CPI, was only 4.5 percent, the lowest annual rate since 1988.

During the first half of 1997, economic activity was sluggish; the economy was still downshifting, and structural adjustment was proceeding.  Amidst the turmoil of structural adjustment, some industries lost price competitiveness to Southeast Asian countries, but high- tech industries such as the information technology industry became new and important players in the economy.  The domestic business environment also became more competitive as entry barriers to foreign firms were lowered.  Occurring at a time of business contraction, the increasing competition led to a greater number of corporate bankruptcies of marginal firms and even some large firms.  Unit export prices export continued to decline, the falling won, and the boom in exports started to narrow the current account balance significantly. 

In third quarter, the economy seemed to finally have bottomed out and begun a slow recovery, though some macroeconomic variables such as ratio of dishonored bills, the exchange rate, and stock prices deteriorated somewhat. Inventories were declining as shipments increased, and owing to the decline in global inventories of heavy and chemical industry products and Korea's 

- 17 -

improving price competitiveness, exports rose by 21.0 percent for the year, helping to rapidly close the current account deficit.

<Table 1>                  Economic Growth¹⁾

(year- on- year, %)

Notes:  1) Percentage changes from the previous year

2) Preliminary

3) Estimates 

Source:  The Bank of Korea, National Account, Various Issues 

<Figure 1>            Industrial Production

- 18 -

Note:  The trend is estimated using the Hodrick- Prescott (HP) filter 

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

The aborning recovery nevertheless proved to be short- lived; the economy deteriorated very quickly in the fourth quarter as the currency crisis gathered force.  Several more large industrial conglomerates went bankrupt, causing banks to become swamped with nonperforming loans, prompting the international credit rating agencies to downgrade Korean banks' ratings and also Korea's sovereign credit rating.  These developments created a vicious cycle of rising bankruptcies, rising burdens of bad debts, credit downgrades, and increasing refusal on the part of Korea's international creditors to rollover loans to Korean banks and enterprises.  This, in turn, created extreme depreciatory pressure on the won, forcing the won/dollar exchange rate to rise to unprecedented levels, reaching nearly 2,000 on December 23.  The Bank of Korea strove to defend the won during the fourth quarter through heavy intervention in the foreign exchange market, but to no avail.  Its foreign reserves were being drained severely, and rumors began to circulate of national default.  Korea finally had no choice but to approach the IMF for a bail- out loan and other assistance.

The currency crisis sent consumer confidence into a nosedive, freezing consumption and causing domestic shipments to decline.  Financial institutions, many of which were fighting for their very existence, called in their loans to firms in efforts to meet the BIS capital adequacy ratio and curbed their foreign currency lending for raw materials imports due to the shortage in foreign exchange.  Nationwide economic production contracted sharply, and the economy went into a deep recession.

Even before the currency crisis hit, both domestic consumption and investment had been weak.  The wholesale and retail sales index rose only 3.2 percent as the recession had dragged on for two long years and income growth had slowed significantly.  Fixed capital formation is estimated to have fallen 3.0 percent, its worst showing since 1981.  In the construction industry, domestic 

<Figure 2>            Inventories and Shipments

- 19 -

construction orders rose only 6.3 percent, and permits for factory construction fell by more than 20 percent in spite of substantial public sector investment in social overhead capital (SOC).  Domestic machinery orders were off by 2.4 percent, and machinery imports fell 15 percent.  Corporate profits had been hurt by the deterioration in unit exports prices, so firms had little incentive or wherewithal to invest.

The 6 percent economic growth registered in 1997 was almost entirely due to exports, the one bright spot of the economy.  Exports were especially robust beginning in the second quarter as the real effective exchange rate depreciated, greatly improving the competitiveness of Korean products(See <Figure 3>). 

<Table 2>                Industrial Activity Index¹⁾

(percent)

- 20 -

Notes:  1)Percentage changes from the previous year.  The figures for 1995 and 1996 were adjusted as 1995 is now being used as the base year for determination of industry weights. 

2) Average facility utilization ratio

3) Seasonally adjusted

4) Annual figures of percentage changes from the previous year

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

The manufacturing production capacity index rose 8.1 percent, even in spite of the stagnation in investment, because of the heavy investment that had been made during the 1994~1995 period and commencement of operation of the new 64M DRAM production lines.  However, because this expansion in production capacity came in the midst of a recession, the factory utilization ratio fell to 78.5 percent, and the weakness in consumption caused the unemployment rate to rise to 2.6 percent.

The economy will skid to a halt in 1998.  Under the IMF program, interest rates must be maintained at high levels and monetary and fiscal policy must be tight.  This will force much needed reform to occur and prevent massive outflows of capital, but it will also drastically lower the economic growth rate to about 0.7 percent.  Private consumption will drop by 1.6 percent and equipment 

- 21 -

investment by 20.8 percent.  Imports will drop 2.0 percent, but because of the weak won, exports are expected to rise by 14.5 percent.  Exports will be the only major engine of economic growth all year.

<Figure 3> Real Effective Exchange Rate and Yen/Dollar Exchange Rate¹⁾

Note:  1) As for the actual estimation of the real effective exchange rate, see the Korean Financial Review, Spring 1996, Vol. 6, No. 1

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

The fall in private consumption will come about because of the decline in real wages and the widespread job insecurity.  Disposable income in real terms will fall sharply due to the increases in taxes, high inflation, pay freezes and pay cuts, and massive layoffs.  Government spending will decline as well, by 9 trillion won, as the government strives to reduce the budget deficit.  All told, total consumption will drop by 1.8 percent.  Investment will likewise decline, by about 12.1 percent.  It will be affected by structural adjustments, high interest rates, and the uncertainties surrounding the economic recovery. 

Exports will increase by about 15 percent on a national account basis.  The depreciation of the won has greatly improved the competitiveness of Korean products on the global market and the international prices for heavy and 

- 22 -

chemical industry products are forecast to recover.  Imports will only grow by 2 percent.  Imports of raw materials needed for production of exports will increase significantly, but imports of consumption goods and capital goods will be well below the previous year's levels. 

The factory utilization ratio will not change much from 1997 as the rise in exports will offset the decline in domestic demand.  Production capacity will drop sharply due to the tremendous reduction in aggregate corporate investment in 1997. This heralds a major deterioration of the job market.  The manufacturing sector will obviously not be a net creator of jobs in 1998; in fact, the wrenching restructuring which is now underway will mean widespread layoffs and high unemployment of up to 6 percent.  In a country where lifetime employment has been a long standing tradition and unemployment has been low for years, the swelling ranks of the jobless will be a serious social problem.

<Figure 4>     Contributions to Economic Growth

The global financial market is another factor which has bearing on the course of the economic recovery in Korea.  If the Southeast Asian currency turmoil becomes especially prolonged in 1998, Korea's exports to the region will fall off greatly, and 

- 23 -

if the American stock market collapses, as some experts who say that it is overheated predict it will, the entire global financial market would be destabilized and asset price deflation would ensue.  These developments would affect Korea profoundly; economic growth would actually become negative, and the recovery of the Korean economy would be delayed.

Interest rates are another concern, and perhaps the paramount concern.  If they hover around 22 percent, economic growth will remain negative and the recession will become even more prolonged due to the high unemployment, widespread bankruptcies, and asset price deflation that would ensue. Furthermore, if banks cut back their lending drastically and greatly exacerbate the credit crunch, the financial system will become largely paralyzed, which would also serve to prolong the recession, in addition to sparking a massive sell- off of corporate real estate.  The declines in real estate prices would then cause banks to incur even greater burdens of nonperforming loans and possibly give rise to a vicious circle of asset deflation and credit crunch.

<Figure 5>  Equipment Investment Plans of the 30 Top Conglomerates

- 24 -

Source:  Korea Federation of Industry

Prices

Mainly due to the stagnation in demand, the CPI rose by only 4.5 percent in 1997, the lowest rise since 1988.  The agricultural product price index rose by only 3.8 percent owing to good weather conditions during the year.  Prices for manufactured products rose by 4.3 percent in spite of the soaring prices for imported goods.  This is mainly due to the stagnant consumer demand and proliferation of discount outlets.  The stagnant demand forced manufacturers and importers to absorb more costs themselves.  Service fees, which had been the major source of inflation for most of the past 10 years, were also stable, rising only 4.7 percent because of the weak consumer demand.

Prices for imported goods soared 36.3 percent, more than they ever have any year since 1980.  International prices for raw materials were stable, but Korean manufacturers had to pay much more for them as the won went into a free fall in the foreign exchange market.  It should be noted that prices for imported goods had been stable for most of the year and, rising only 3.4 percent through October, and did not spike until the last two months of the year, when Korea was lashed with the full force of the currency crisis.  They rose by 26 percent in December alone. 

The Producer Price Index (PPI) rose by 3.9 percent.  Like the CPI, it spiked in December, rising at an annual rate of 10.9 percent.  The hikes in prices for oil, electric power, and gas, all of which stemmed from the Korean won's decline, were the major sources of upward pressure on the PPI. 

<Table 3>                    Inflation¹⁾

(percent) 

- 25 -

Notes:  1) Percentage changes from the previous year 

2) Forecasts

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

The Bank of Korea, Monthly Bulletin, various issues

Manufacturing workers' wages rose only 10.3 percent in 1997.  Early in the year, the unemployment rate rose to 2.9 percent as industrial restructuring proceeded.  The widespread feeling of job insecurity held wage increases in check at low levels.

Real estate prices were stable.  Land prices rose only 1.2 percent, which considering the inflation rate means that land prices in real terms actually fell. Prices were held down by the lack of demand for real estate and massive sell- offs of real estate by cash- strapped firms.  The real estate market in 1997 was clearly a buyers market, and it be so in 1998 as well.

The CPI is projected to rise by 10.1 percent in 1998.  The upward pressure on prices will stem almost entirely from the depreciation of the won.  Imported goods prices will be much higher than in 1997.  There will be little if any demand- pull inflation as disposable income declines.  Because the won collapsed very late in 1997, most of the inflationary pressure resulting from it will be felt in 1998.  Energy prices will therefore continue to rise for some time, forcing up the prices of almost all other products.  The increase in prices for imported raw materials and intermediate goods such as wheat flour, sugar, and iron will also create upward pressure on prices during 

<Figure 7>   Imported Goods Prices and the Won/Dollar Exchange Rate

- 26 -

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

the year.  Even the high interest rates will serve to push prices up.  They will translate into higher interest payment burdens, forcing manufacturers to pass some of the increased financing costs on to consumers.  The prices of manufactured goods are projected to rise by more than 16 percent.

Taking core inflation (the rate of inflation excluding food and energy prices) into consideration, the weakness in consumption will counter some of the inflationary pressures in 1998.  Core inflation rose more quickly than the CPI during 1995, when the last business cycle was at its peak, and in 1996, but it began to lag the CPI in 1997 due to the prolonged recession and contraction in purchasing power.  The weak demand will especially counteract inflation in the service sector.  Service fees will rise about 6.1 percent, only slightly more quickly than in 1997.

The Producer Price Index (PPI) will be affected the most of all by the increase in import prices, soaring by as much as 21.1 percent.  Wage growth will be flat, and real estate prices will likely decline due to mass sell- offs by cash- strapped firms and the contraction in demand for housing.

- 27 -

<Figure 6>          CPI and Sources of Inflation

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

Current Account and Foreign Exchange Rate

The 1997 trade deficit and invisible trade deficit were recorded at 2.8 billion dollars and 6.3 billion dollars, much lower than in 1996.  There was a surplus of unrequited transfers of 0.3 billion dollars.  The current account deficit narrowed by nearly 63 percent to 8.9 billion dollars.  The capital account surplus was much reduced due to short- term foreign debt redemptions and the massive outflow of portfolio investment funds that occurred at the end of the year.  It is estimated at 8.0 billion dollars.  The won depreciated by 50.2 percent against the dollar during 1997, falling to the level of 1,695 to the dollar by the end of the year.  On average, the won/dollar exchange rate was 953.6 for the year. 

In dollar terms, exports grew 7.2 percent in 1997.  Unit export prices fell by 15.6 percent as a result of a global oversupply of petrochemical and electronic products and pressure by foreign buyers on Korean exporters to lower prices due to the Korean won's depreciation.  Export volume grew almost 25.0 percent owing to the 

- 28 -

vastly improved price competitiveness.  Exports of electronics products recovered due to a major increase in shipments of 16M DRAM chips and non- memory semiconductors.  Even in dollar terms, exports of 16M DRAM chips were up despite the global decline in prices for them.

<Table 4>                   Balance of Payments¹⁾

(100 mil. dollars)

Notes:  1) The figures for 98 are forecasts

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

Imports declined for the second year in a row.  Imports of raw materials grew by 20 percent as manufacturers had to step up production of goods for export, but imports of consumer goods and capital goods were much reduced; the weakness of the won priced many imported goods out of Korean consumers' reach, while firms cut back their investment in capital goods.  Total imports were down by 21.8 percent (yoy) at the end of year.  Up until November 1997, Korea's balance in trade with every major region except for the Middle East had been improving.  In bilateral trade, Korea recorded a deficit of 12.3 billion dollars vis- a- vis Japan and a deficit of 8.6 billion dollars vis- a- vis the United States, which in both cases represent major improvements from 1996.  Korea's combined trade balance with Southeast Asia, China, and Eastern Europe rose sharply to 23.8 billion dollars.  The trade balance with the Middle East deteriorated because of increases in international petroleum imports and the fall of the won. 

The deficit in the invisible trade balance narrowed slightly in spite of a deterioration the investment income balance.  The improvement in invisible trade was 

- 29 -

mainly due to improvements in the travel balance and royalty payments.  During the first ten months of 1997, the monthly average invisible trade balance was a deficit of 0.7 billion dollars.  In November, the deficit fell suddenly to only 0.2 billion 

<Table 5>         Quantity and Unit Export Prices¹⁾

(percent)

Notes:  1) Percentage changes from the previous year, FOB

2) Monthly through November, 1997

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

dollars and then reverted to a surplus of of 0.2 billion dollars in December.   The deficits in the shipping and transportation balances deteriorated, however, due to the growth in exports, and the investment income balance deteriorated due to rise in Korea's external debts and interest payments.  The investment income deficit for the year amounted to 3.7 billion dollars.

<Table 6>  Exports and Imports by Commodity, Purpose, and Region¹⁾

- 30 -

Notes:  1) Percentage changes from the previous year.  The figures in parentheses are percentage shares.

2) Averages through November, 1997

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

The surplus in the capital account fell to 8 billion dollars, roughly half its level in 1996.  Korean financial institutions and firms had been able to issue bonds on the international financial market with relative ease through the end of the third quarter, pushing the capital account surplus up to 11.3 billion dollars. The situation was completely different in the fourth quarter as Korea's international credit ratings were drastically downgraded and the won crashed. Koreans entities could no longer find underwriters for their bond issues on the international market, and foreign investors withdrew all types of investment funds from Korea en masse.  For the first time since the stock market was opened to 

- 31 -

them in 1992, foreign investors actually recorded a net annual outflow of portfolio investment funds in 1997.  Similarly, according to preliminary estimates, the long- term capital account is projected to have recorded a deficit of 3 billion dollars deficit in the fourth quarter. 

<Table 7>            Invisible Trade Balance and Unrequited Transfers

(Million dollars)

Notes:  The figures for the third and fourth quarter are preliminary

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

Most of the reduction in the capital account surplus occurred in the short- term capital balance.  The deficit in the short- term balance for the entire year is estimated at 2 billion dollars.  Much of the outflows occurred at the end of the year.  Flows of foreign capital had resumed early in the year as the turmoil following the bankruptcy of Hanbo Steel in January began to dissipate.  However, the markets reacted badly to the near- bankruptcy of Kia Motor in July; the inflows of foreign capital slowed very suddenly to a trickle.  Exacerbating matters, both Moody's and S&P downgraded Korea's credit ratings, preventing most Korean banks from being able to rollover the loans they had taken out from foreign creditors.  The won fell precipitously due to the extreme shortage of dollars which ensued, prompting the Bank of Korea to intervene aggressively in the foreign exchange market to stem the won's depreciation as much as possible.  The depreciatory pressures ultimately proved too great; the Bank of Korea's foreign exchange market interventions only succeeded in draining foreign reserves.  When the Bank of Korea's reserves fell to an extremely critical level and it became obvious that it could not afford to intervene in the 

- 32 -

foreign exchange market or cover Korean banks' foreign debts much longer, Korea finally approached the IMF for assistance.

The won/dollar exchange rate soared to 1695.8 won by the end of December from 842.7 won at the beginning of the year.  In the first quarter, the won depreciated in the wake of the Hanbo debacle as foreign capital inflows had been temporally discouraged.  From April to July, the markets' sentiment was much better; exports began to recover, and the won actually appreciated slightly.

<Table 8>                         Capital Account 

(Bil.  Dollars)

Notes:  The figures for 1997 represent the totals through November

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

The won began to slide again in September as investor confidence had been hurt by the near- bankruptcy of the Kia Group and the eruption of the currency crisis in Southeast Asia.  Demand for dollars was so great that the won/dollar exchange rate hit the upper bound of the daily 2.25 percent fluctuation limit on several consecutive trading days.  The fluctuation band was then widened to plus or minus 10 percent on November 20, 1997, and when even that limit proved untenable, the band was completely abolished on December 16 1997.

The causes of the currency crisis are both varied and complex, and they are all inter- related.  American industry has become much more competitive in recent years, 

- 33 -

thus forcing the dollar up, while Korea for several years had been incurring deeper and deeper current account deficits.  Korea obtained needed dollars by means of attracting foreign portfolio investment and by taking out large volumes of short- term external debt.  When the international financial community began to question whether Korea's current account deficit was sustainable and Korean financial institutions had taken on enormous amounts of short- term debt, the international credit rating agencies began to downgrade Korea's credit ratings, thus preventing Korean financial institutions from obtaining more foreign credit or from even rolling over much of the credit that they had already been granted.  It would also seem that there had been a bank run on Korea and that Korea had been affected by the contagion of the Southeast Asian crisis.  Foreign investors not only reduced their exposure to Southeast Asia when the economic situation there turned extremely sour but also withdrew much of their investment capital from Korea, even though Korea's economic fundamentals were better than those of the Southeast Asian countries. 

<Figure 9>  Won/Dollar Exchange Rate and Won/Yen Exchange Rate 

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

The current account balance began to improve sharply in October.  The domestic 

- 34 -

capital markets were relatively closed to speculative investments, so there was not very much flow in speculative hot money in either direction.  The supply and demand for foreign exchange had been improving just before the currency crisis broke out.  The fundamental causes for the currency crises can be found in the structural weaknesses of both Korea's financial and industrial sector.  Financial institutions borrowed short- term and lent long- term, many firms and institutions were reckless in their investment, and there was a woeful lack of government supervision.

Both the current account balance and the trade balance will be much improved in 1998; they are forecast to record surpluses of 10.9 and 3.0 billion dollars, respectively.  This should begin to pull down the won/dollar exchange rate at the end of the year.

Exports are projected to rise 7 percent to 147.5 billion dollars.  Korea's exports of 64M DRAM chips, machine tools, and automobiles will all grow sharply, and shipbuilding orders should be up as well.  Exports of steel and petrochemical products will grow strongly as international prices recover.  Exports to Southeast Asia will not increase much and may even decline due to the ongoing financial turmoil, but exports to most all other regions and the advanced countries should post healthy increases.

Imports will drop slightly to 136.7 billion dollars.  The growth in exports will spur growth in imports of raw materials and intermediary goods, but a considerable amount of intermediary goods will be substituted by domestic goods due to the steep hike in import prices.  The fall in corporate investment and the national effort to conserve oil will dampen exports even further, and imports of consumer goods will plummet.  In the invisible trade balance, the travel balance will post a surplus, while the deficit in the investment income balance will rise because of the mushrooming of Korea's external debt and Korea's enormous interest payment burden.  The total invisible trade deficit is estimated at 8.6 billion dollars

The surplus in the capital account is forecast at a tremendous 30 billion dollars. According to agreements hammered out with foreign creditors, Korea will not have to redeem much of its total external debt this year, and foreign investment in Korean 

- 35 -

equities will almost certainly explode seeing as Korean stocks in dollar terms are now major bargains.  Foreign investment in Korean bonds will begin to rise as soon as Korea's credit ratings are upgraded to the next level- - presently they are at the highest possible rating for junk bonds- - and the foreign exchange market shows sustained stability.  Inflow of funds pledged by the IMF and World Bank as part of Korea's bail- out package, the issuance of foreign exchange stabilization bonds, and the issuance of syndicated loans will altogether bring in 40 billion dollars.

The exchange rate should stabilize after the second quarter.  The overall balance is projected to record a surplus of more than 30 billion dollars.  The Bank of Korea will take full advantage of this situation by continuing to buy dollars from the foreign exchange market in order to rebuild its foreign exchange reserves, thus preventing the exchange rate from dropping very much.  In the first quarter, the won/dollar exchange rate will hover around 1,600.

In the second quarter, the current balance account surplus will be widen sharply, finally pulling the exchange rate down somewhat.  The won should appreciate more rapidly in the second half because foreign investment in Korean equities and bonds will likely rise as Korea's economic situation will have greatly improved by then. The won/dollar exchange rate will move in the range of 1,450~1,550 won during the first half, and 1,250~1,350 won during the second half.

<Figure 8>      Overall Balance and Exchange Rate 

- 36 -

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

- 37 -

Money and Interest Rates

1. Money

The MCT growth rate continued to downtrend all throughout 1997 due to the business slowdown and conservative asset management by commercial banks.  The M2 growth rate remained relatively high at 19 percent as large volumes of funds flowed from trust accounts to bank accounts.  The volume of reserve money continued to fall due to consecutive reductions in the reserve ratio and a corresponding reduction in the total lending limit intended to absorb the liquidity created by the lowering of the reserve ratio.  The conflicting signals of the monetary aggregates were attributable to the reform of the trust system, the lowering of the reserve ratio, and the more frequent shifting of funds between monetary assets which occurred as a result of the introduction of a number of new financial products. 

The MCT growth rate decelerated as banks increased their issuance of bills backed by paper in order to avoid the higher expenses of issuing CDs, which had become subject to reserve requirements.  The higher M2 growth rate is partly attributable to the rise in residents' foreign currency deposits; many residents rushed to open foreign currency accounts to hedge against the instability in the foreign exchange market, especially in the fourth quarter.  The shift of funds from MCT to M2 resulted in increased market liquidity via credit creation, but no noticeable changes in market liquidity could be observed because of the increased shifting of funds between monetary assets.  The money multiplier tended to increase for all monetary indicators; it especially moved up for the monetary base as a result of pronounced cuts due to the lowering of the reserve requirement.  The velocity of money, which generally varies indirectly with the demand for financial assets, increased over a short period as a result of the greater market uncertainties over possible business failures.

The direction and volume of capital inflows were the major determinants of the money supply during the first and the fourth quarters, reflecting the especially widespread expectations concerning capital flows during those times.  In the fourth quarter, the volume of capital inflows fell to a trickle as the international credit rating 

- 38 -

agencies successively downgraded Korea's credit ratings, especially after the Kia debacle and the eruption of the East Asian currency crisis.  The private sector continued to account for a robust increase in the money supply as the Bank of Korea strove to offset the contractionary impact of the reduction in money supplied from overseas. 

<Table Ⅲ- 1>    Monetary Growth Rates, Multipliers, and Velocities¹⁾

(percent, times)

Note:  1)Year- on- year period average percentage changes.  The figures for the second quarter are preliminary.  Money Multipliers are the ratios of each monetary aggregate to the volume of reserves.  The velocities of money represent the ratios of seasonal adjusted nominal GDP of each monetary aggregate.  The velocities reported in this issue of the KFR are annual velocities; the velocities reported in the last issue were quarterly velocities.  Seasonal adjustments also account for 

- 39 -

slight differences.

2)Estimates. 

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

4)M1 = currency + demand deposits. 

5)M2 = M1 + savings deposits + foreign currency deposits

6)MCT = M2 + CDs + money- in- trusts

7)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, Currency Monetary Statistics, various issues 

Of all the the monetary measures taken in the first quarter, the reforms in the call market and changes in the reserve requirement were of especial significance.  Before the integration of the call markets, it was not unusual for capital flows to become disrupted as securities firms continued to borrow in the call market to cover their operating expenses.  For this reason, the Korea Money Broker Corporation was established in November 1996.  It specializes in call transactions, permitting the monetary authorities to easily detect liquidity shortages in the market and, therefore, making monetary policy much more responsive.  The authorities also lowered the reserve requirement and reduced the total lending limits in order to lay the foundation for indirect control of the money supply.  The reserve requirement was lowered from 5.5 percent to 3.5～4.0 percent, and CDs were made subject to a 2 percent reserve requirement with no limits on issuance.  The liquidity created by the lowering of the reserve requirement was absorbed by reducing the total lending limit from 6,400 billion won to 3,600 billion won. 

In the third quarter, the Kia group's near- bankruptcy greatly exacerbated the already serious cash flow problems at financial institutions.  The Bank of Korea responded by extending a special loan of 1 trillion won to ailing Korea First Bank and to merchant banks.  However, to dispel the public's concerns about preferential treatment, an 8% interest rate was attached to the loans, the average cost for financial institutions' financing,  Contrary to expectations, this injection did not improve the market situation noticeably.  The financial market was not actually suffering from a temporary shortage of liquidity, but rather, from a credit crunch stemming from the high corporate credit risks. 

- 40 -

<Table Ⅲ- 2>            MCT Money Supply Growth by Sector¹⁾ 

(Billion Won)

Notes:  1) End of period changes form the previous period.

2)Estimates.

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

The Bank of Korea, 『1997 Monetary Trends』. 

<Table Ⅲ- 3>     Deposit Changes at Financial Institutions¹⁾

(Billion won)

Notes:  1)Average period changes

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

The Bank of Korea, 『1997 Monetary Trends』

<Figure Ⅲ- 1> RPs Outstanding and Issuance of Monetary Stabilization Bonds

- 41 -

Monetary policy changed greatly as the currency crisis took hold in Korea and after Korea accepted the IMF reform program.  The change was reflected in the movements of the monetary aggregates.  The Korean government was obligated under the IMF program to raise interest rates to extraordinarily high levels in order to reverse the outflow of capital, and structural adjustments were pursued.  This created extreme financial pressures on firms, causing the dishonored bill ratio to skyrocket to 1.49% in December.  Worsening the situation, the banks reined in their corporate lending as they were under great pressure themselves to meet the BIS capital adequacy ratio, and merchant banks almost completely discontinued their discounting of commercial paper (CP), the major source of corporate short- term borrowing.  All of this created a severe financial panic in December. 

Before the currency crisis broke out, monetary policy had been geared towards easing the financial crunch to prevent further corporate bankruptcies.  After the Korean government reached agreement with the IMF on the reform program, monetary policy was tightened up and M3 and the monetary base were used as the monetary targets instead of MCT.

The liquidity in the market began to increase when the inflow of foreign capital resumed, but the monetary authorities quickly acted to absorb the increase in the 

- 42 -

money supply through daily RP operations, as required under the IMF program. 

<Figure Ⅲ- 2>  Elasticity of Monetary Demand to Exchange Rate Movements

Forecasts

The rate of monetary growth in 1998 will be largely determined by the exchange rate and volume of foreign capital inflows.  The monetary base is the sum of Net International Reserves (NIR) and Net Domestic Assets (NDA).  The IMF has required that the monetary base growth rate not exceed 14.9% and minimum net foreign reserves of 20 billion dollars.  If the won/dollar exchange rate does not fall below 1,300, the volume of net domestic assets must decline, bringing about a contraction in the availability of domestic credit (See Table III- 4).  In spite of the seemingly high 14.9% rate of increase in the monetary base, the contraction in the money supply and the credit crunch will continue in 1998.  The availability of liquidity, indicated by 

- 43 -

M3, will be about 94.5 trillion won, slightly less than the figure of 96.5 trillion won in 1997. 

The IMF assesses the substantiality of the external debt and sets the target for the current account balance at whatever level it deems is required for substantiality to be maintained.  Improvement of the current account balance is largely achieved by means of monetary contraction and high interest rates.  The contraction of the domestic economy may greatly improve the current account balance as it causes demand for imports to plummet, but it also gives rise to high unemployment and other ills and can conceivably lead to some degree of social upheaval.

<Table Ⅲ- 4>       Monetary Growth Rates and Forecasts 

(Billion won)

Notes: 1) Net International Reserves = Usable International Reserves -  IMF bail- out loan -  the volume of long forward exchange positions

2) Net International Reserves at the end of March will be 8.1 billion dollars in accordance with the agreement with the IMF.  NIR at the end of 1998 is assumed to be 20 billion dollars.

Inflows of foreign capital and stability in the foreign exchange market are the most important factors for easing the contraction in the money supply.  Thankfully, the market is giving some positive signals.  As the exchange rate adjusted interest rate spread began to improve in January, many foreign investors returned to the stock market, registering an aggregate net purchase of 1.7 trillion won for the month, and their aggregate bond investment (the bond market had just been fully opened to foreign investment in January) amounted to 328 billion won for the month.  Exchange 

- 44 -

rate stability is necessary, however, to also lower the high interest rate by allowing for expansion of the money supply.

Exchange rate and price stability must be the major objectives of monetary policy under the IMF program.  This is even more important at the present time as the drastic changes occurring in the financial sector and the external factors such as the Southeast Asian currency crisis have all increased the uncertainties concerning the supply and demand for money.  Moreover, Korea is now widely exposed to international capital movements and is using a system of free floating exchange rates, in accordance with the IMF program.  Determining the proper policy mix in conducting exchange rate and monetary policy to ensure adequate liquidity to resolve the financial crunch will therefore prove challenging.  Moreover, the IMF and monetary authorities will experience great difficulty in deciding which monetary 

<Figure Ⅲ- 3>                 Spread

Notes: Spread = Corporate Bond Rate -  LIBOR -  Change of Exchange rates

aggregate to use as a gauge as financial opening progresses.  Korea has already experienced instability in money demand stemming from the arbitrage transactions between won- denominated assets and foreign currency- denominated assets.  As a 

- 45 -

result, the mix for the time being must focus on exchange rate stability and taming inflation.  Price variables such as the interest rates and exchange rate will be more important as policy instruments than direct control of the money supply.  In fact, the intermediate target strategy focusing on quantity variables is no longer viable as the relations between the money supply and prices and controllability of money aggregates have been weakened.  It would therefore be appropriate to use revised inflation targeting, according to which the inflation target is set based on the forecast of future inflation.

Financial market opening can expose the Korean economy to extreme instability arising from flows of speculative hot money.  Another important objective of monetary policy is therefore to safeguard the financial market from the ravages that sudden inflows or outflows of short- term capital can cause.  The government will formulate measures to attract more Foreign Direct Investment (FDI) rather than short- term capital.  The free floating exchange rate regime will prove helpful towards absorbing foreign shocks, but a domestic currency futures market has yet to be established.  The establishment of a currency futures market should be given high priority as it would would greatly reduce the volatility of the exchange rate and, therefore, exchange rate risk.

<Figure Ⅲ- 4> Exchange Rates and Money Supply from Overseas

- 46 -

The IMF and the monetary authorities agreed to use the monetary base as an intermediate target, but the targeted monetary growth rate will be set according to developments in the foreign exchange market.  In spite of the recent acceleration in monetary growth, this change is not meant to ease the monetary contraction, but rather, to deal with the higher rate of inflation.

A great deal of money will be supplied from overseas, while money will be absorbed domestically.  The rebuilding of foreign reserves is a major priority at the present time, and this of course requires monetary expansion from overseas sources.

For a number of reasons, the M3 growth rate should be raised to 16~17%, substantially higher than the targeted rate of 13~14%.  Considering the fact that MV=PY, liquidity must be increased if economic activity is to continue in light of the fact that inflation is running above 10%.  Higher monetary growth will also reduce the relatively high market risks stemming from the ongoing structural adjustments and sweeping financial opening, thereby promoting recovery of the financial system. 

2. Interest Rates

- 47 -

In spite of the low inflation and monetary growth rates, interest rate did not fall in the third quarter of 1997 due to the greater credit risks. 

In the first quarter, the benchmark corporate three- year bond yield rose due to the bankruptcy of the Hanbo group and the increasing operating expenses arising from the bloated inventories.  In the second quarter, the demand for money declined as firms cut back their outlays for equipment investment and strove to reduce their inventories. Moreover, financial institutions directed the bulk of their available funds towards bond investment rather than extending loans to firms, which was inherently much more risky.  However, contrary to expectations, the three- year corporate bond yield remained stubbornly high; fears of over more potential bankruptcies of large firms were very widespread.  In the third quarter, the CB yield stayed at 12.09%. Although corporate money demand had fallen off and the monetary authorities provided adequate liquidity to restore some degree of stability to the financial market, the high credit risks and firms' increasing difficulties in accessing foreign capital formed expectations of a future increase interest rates. 

The money market was extremely polarized in 1997.  While the most creditworthy firms were able to obtain sufficient amounts of money from the market, other firms were denied money and therefore suffered serious cash- flow problems. The dishonored bill ratio soared to 0.23% in the first quarter, its highest level since 1980.  The credit crunch continued into the second quarter, even though financial institutions were relatively flush with cash; they invested their funds in corporate and government bonds, which were relatively safe investments compared to corporate loans.  The volume of CP discounted by merchant banks fell by 2 trillion won; in spite of the falling interest rates, the dishonored bill ratio remained high and firms continued to experience cash- flow problems.  In the second half of 1997, the credit crunch became so serious that even large conglomerates became affected and the dishonored bill ratio rose even higher.  The Bank of Korea intervened heavily in the foreign exchange market in an effort to halt the won's depreciation, and financial institutions absorbed money from the domestic financial market to obtain dollars for 

- 48 -

repayments of their external debts.  As a result, the money market experienced a serious shortage of liquidity.

In the first quarter, the yield curve very inverted.  It then became flatter in the second quarter.  Financial institutions, being very reluctant to extend loans to firms at that time, used their available funds on a daily basis in the call market or invested them in CDs.  This caused the short- term interest rate to fall, flattening the yield curve out.  In the third quarter, the prolonged financial market instability caused the short- term interest rates to rise again.  The call rate rose the most sharply of all rates, causing the yield curve to become inverted yet again; in fact, the yield curve became even more steeply down- sloping than it was in the first quarter. 

<Table Ⅲ- 5>         Major Interest Rates by Quarter

(%)

Source:  Korea Investors Services, KIS- LINE

Interest rates were not very volatile in the first half as financial institutions had sufficient money in spite of the cash- crunch many firms were then experiencing.  The failure to bring a timely resolution to the Kia debacle, however, caused fears in the market among both domestic and foreign investors to rise, leading to greater financial market instability.  The interest rates rose sharply and fluctuated widely.

In spite of the decline in money demand and the adequacy of the money supply early in 1997, the three- year corporate bond yield did not fall below 12%.  It had in fact refused to fall below that level since the third quarter of 1996.  The spate of bankruptcies which occurred after the collapse of the Hanbo group led to increases in the risk premiums of Korean firms and therefore rendered Korean firms and financial 

- 49 -

institution's efforts to access the international money market more difficult..  This, in addition to the high monetary growth, created expectations of further interest rate hikes.  It was also during this time that the exchange rate became one of the major determinants of the interest rates.  The interest rate spread was very wide, but the foreign exchange rate risks became so great that a massive outflow of foreign capital occurred in the third and fourth quarters.  The beginnings of this outflow had begun in September and gained momentum afterwards, turning into an outward bound flood in the fourth quarter.  The Southeast Asian currency turmoil clearly rendered Korea's situation more difficult.  Korea's sound economic fundamentals did not safeguard the economy from the contagion of the Southeast Asian crisis as it had already become exposed to external shocks and, even now, no mechanisms have yet been put in place to absorb such shocks.

<Figure Ⅲ- 5>        Dishonored Bill Ratio

<Table Ⅲ- 6>          Determinants of Interest Rates 

- 50 -

(percent, billion Won)

Notes:  1) Year- on- Year growth rates

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

Korea Investors Services, KIS- LINE

<Table Ⅲ- 7>         Major Indicators of Flow of Funds 

(%,number)

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

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

Korea Investors Service, KIS- LINE

- 51 -

<Figure Ⅲ- 6>           Yield Curves in 1997

First Quarter Yield Curve

Second Quarter Yield Curve 

Third Quarter Yield Curve 

Fourth Quarter Yield Curve

- 52 -

All interest rates skyrocketed after Korea approached the IMF program for a bail- out loan package.  Banks desisted from extending loans to firms; even many of the largest and most creditworthy firms experienced difficulties in obtaining bank loans.  Only the four largest conglomerates could obtain money from the market through issuance of CP and corporate bonds, but even they had to pay interest rates which were higher than ever before.  The CP rate soared to the dizzying height of 40.8% in December from 16.9% in the November, and the CB yield rose to 30.9% from 14.08%.  As interest rates skyrocketed, some banks began to offer new financial products which bore interest rates of 25% to depositors.  This kind of cut- throat competition to win depositors badly eroded banks' profits, forcing them to raise the interest rates on loans. 

<Table Ⅲ- 8>        Daily Absolute Change in Interest Rates

(Unit : %p)

Notes:  Periodic average of the absolute change in interest rates. 

<Table Ⅲ- 9>                 Bond Issuance

(billion won)

Source:  Securities Supervisory Board, Monthly Review

- 53 -

<Figure Ⅲ- 7>    Interest Rate and Exchange Rate Volatility

Interest Rate Volatility                   Exchange Rate Volatility

Note:  **The volatilities were estimated using GARCH (1,1)

<Figure Ⅲ- 8>  Won/Dollar Exchange Rate and Corporate Bond Yield

- 54 -

<Figure Ⅲ- 9>  Dishonored Bill Ratio and Land Price Increase Rate

<Fig Ⅲ- 10>            Frequency of Bankruptcies by Firm Size

- 55 -

In accordance with the agreement with the IMF, the Bank of Korean has been absorbing money through RP sales to financial institutions.  The monetary contraction can be expected to continue all through the year, and the resulting credit crunch has almost completely paralysed the financial market's intermediary mechanism.  Banks are extremely reluctant to extend loans to firms as they are under severe time pressure to meet the BIS ratio, and because they are now locked in cut- throat competition with each other, they are offering depositors high interest rates.  This situation threatens to aggravate the adverse selection problem and delay the exit of ailing financial institutions.  Moreover, another spate of bankruptcies of cash- strapped firms could cause banks to become even more heavily burdened with nonperforming loans, threatening to pull down the entire financial system.

Under such adverse conditions, the economy will grow only about 0.7% in 1998, and the dishonored bill ratio and unemployment rate will rise to 0.74% and 6.2% respectively.  Corporate profits will be poor; many firms have suffered foreign exchange losses and have seen their interest payment burdens rise greatly.  In spite of the ongoing boom in exports, the unit export prices will not likely improve because of competitive currency devaluations in Southeast Asia and demands by importers in foreign countries for price discounts matching the margin of currency depreciation. 

The extraordinarily high interests rate will push a greater number of firms into bankruptcy, thereby causing banks to become even more awash in nonperforming loans.  The high rates also threaten to bring about asset deflation and to prolong the recession.  If interest rates remain at their prevailing levels and economic growth is low for more than one year, Korea's long- term growth potential will be seriously reduced.  This would defeat the purpose of the IMF program.

Forecasts

Financial market instability will almost certainly be the prime concern for market participants.  Korea is braced for major financial restructuring and increased inflows of capital due to the far- reaching market liberalization which has been executed.  In 

- 56 -

the midst of the Southeast Asian financial crisis, it is feared that the Korean financial market may continue to be affected by contagion and that the domestic instability associated with the financial reform will not dissipate for a long time.

The IMF bailout effort is expected to exercise greater influence on the relative weights of major factors in favor of international aspects: the expected exchange rate and interest rate differentials are expected to play a significant role in the opening of the short- term bond market and liberalization of short- term financial instruments. Even though the volume of capital inflows is not very high at present, they should rise greatly due to the contractionary monetary policy when the current risk factors begin to subside.  What is most notable is the diminishing role of traditional macro variables as determinants of the interest rates in comparison with institutional changes and the clearing of bad loans at financial institutions; the latter are expected to exercise a crowding out effect on interest rates, preventing them from coming down for some time.

A higher frequency of corporate bankruptcies amid a severe recession and credit crunch could very well emerge as a serious social problem.  Econometric evidence at the KIF suggests that the dishonored bill ratio increases by 0.014 percentage points after three months for every one percentage point increase in the market interest rate. The intended policy effect of the contractionary policy definitely entails serious side effects because the worsening credit crunch has certainly exacerbated the already serious cash- flow problems at many firms.  Even some otherwise financially healthy firms may very well fall due to lack of liquidity.  Also, the logit estimation results show that the probability of the bankruptcy ratio being even higher than that of the previous year is 0.93, a stark indication that the situation will get much worse before its gets better.  The simultaneous increase in both the bankruptcy ratio and unemployment rate is expected to overwhelm the economy; the original projections are now deemed too optimistic.  If the effects of the closures of merchant banks are taken into account, the growth rate could fall as low as - 1.7 percent, while the market interest rate will shoot up seven percentage points.  Clearly, the current monetary stance is stifling the economy; the adverse side effects of the IMF reform 

- 57 -

program would seem to far outweigh the positive benefits.

No sizable increase in monetary demand is forecast due to the seriousness of the recession and the lack of incentive for firms to make outlays for facilities investment. However, the demand for liquidity will remain high due to the serious contraction in consumption and the difficulties in obtaining external financing.  The conditions for overseas borrowing will singularly determine the financial conditions of large corporations because the monetary authorities has been deprived of any discretion in setting the supply of credit under the IMF program.

The overall demand for money from other sectors will nevertheless increase in the presence of the tremendous need to pursue structural adjustment.  Most importantly, nonperforming loans at banks need to be cleared, and external debt desperately needs to be paid down.  The authorities are expected to raise 24 trillion won for the resolution of bad loans and deposit insurance purposes (12 trillion won for the resolution trust at the Korea Capital Management Corporation and 12 trillion won for deposit insurance) by means of issuance of government bonds and another 10 billion dollars (1 billion on the domestic market, 9 billion on the overseas market) via issuance of foreign currency denominated- bonds.  The authorities also plan to issue 300 billion yen in national bonds in March to Japanese residents to expand the Bank of Korea's foreign reserves.  On the supply side, the foreign exchange market should regain stability in the second half, prompting increased capital inflows from overseas. 

Some upgrading of Korea's credit ratings has already occurred following the debt rescheduling talks in New York.  Continued upgradings will facilitate Korea's efforts to overcome the current liquidity crisis, allowing Korea to resume borrowing in the international financial market and at more favorable rates.  Improvement in investor sentiment coupled with various liberalization measures may encourage significantly increased inflows of foreign capital.  In fact, dramatic changes could conceivably 

<Figure Ⅲ- 11>     Impulse Response of Dishonored Bill Ratio 

by 1%p Shock of Interest Rate

- 58 -

occur in the short- term bond market as investors can avoid the exchange rate risks associated with long- term investment.  It would therefore seem that short- term interest rates are poised to fall before the long- term rates, thus widening the interest rate spread.

<Table Ⅲ- 10> Growth Rate and Dishonored Bill Ratio at Different Interest Rates

<Table Ⅲ- 11> Dishonored Bill Ratio and Number of Corporate Bankruptcies 

at Different Economic Growth Rates

- 59 -

<Table Ⅲ- 12>  Economic Effect of Bill Discounting

(Unit: %)

Inflationary pressure will peak during the first half of 1998 since the Korean won is down by more than 40 percent against the dollar from its level of six month ago. The prices of manufactured goods and all imported raw materials will rise and account for almost all of the inflationary pressure.  Wages and service charges will be flat or even decline due to the weakness in consumption and partly offset the general rise in the price level.  The inflation rate is expected to be more moderate in the second half because domestic demand will plummet even further in the wake of what is expected to be an unprecedented rash of corporate bankruptcies all over the country. 

Interest rates will only begin to mark a stable downward trend when the exchange rate shows stability.  In order for the IMF reform program to be effective, foreign investor confidence in Korea must be restored.  This more than anything else is the key to Korea's recovery; the situation is crucial since the inertial impact of the exchange rate on interest rates can spark a virtuous circle.  Otherwise, continued instability in the foreign exchange market will prolong the current credit crunch and 

- 60 -

seriously reduce the growth potential of the economy.  In recognition of Korea's serious problems, including the need for deep structural adjustment and its enormous external/internal debt burdens, an optimistic forecast for the intermediate future cannot easily be made.  The next several years will be full of challenges for the market participants as they will have to negotiate the increased risks associated with greater interest rate and exchange rate volatility.

<Table Ⅲ- 13>    Ratio of Firms' Shortage of Funds to Nominal GDP

(Unit:  Billion won)

Notes:  Scenario 1; capital inflows increase: Scenario 2; capital inflows remain at current level (the average until the second quarter of 1997): Scenario 3; capital inflows decline.  The figures in parentheses indicate the amounts of firms' shortages of funds.

The economic fundamentals suggest that the interest rate will remain high for several years unless steady inflows of private capital can be sustained without disruptive effect on the domestic economy.  However, given the uncertainties concerning the structural adjustment effort on broad sectors of the economy, interest rates will be more volatile, even with free floating exchange rates. 

<Table Ⅲ- 14>          Changes in Korea's Credit Ratings

- 61 -

<Figure Ⅲ- 12>      Movements of the Bank Loan Interest Rate

All in all, foreign factors will determine the direction of future interest rate movements.  In addition to uncertainties that can temporarily disrupt financial flows, the interest rates will be largely influenced by developments in the foreign exchange market, especially with regard to changing expectations about the future exchange rate.

Econometric evidence shows that since the Kia debacle, the chain of causality from interest rates to stock prices to the exchange rate, which had been long 

- 62 -

observed in the past, has been reversed; the causality now begins with the exchange rate affecting the interest rates, which then affect stock prices.

As previously pointed out, the most important factor that will affect interest rate movements is the volume and the timing of capital inflows.  It is noteworthy that the composition of capital inflows as well as their volume can be important in influencing the interest rates; volatile capital movements can destabilize the economy through drastic changes in the exchange rate.  Furthermore, Korea's present external economic situation is not conducive to exchange rate stability.  The first half will witness volatility since the policy measures for clearing the bad debts at financial institutions have not yet been firmly established; a great deal of market uncertainty remains. With drastic regime changes in the economic environment and the enormous burdens of structural adjustment expected to give rise to greater exchange rate and interest rate volatility, the possibility of an increase in short- term interest rates is very high.

<Figure Ⅲ- 13>  Interest Rate Spread 

There is almost no possibility of monetary loosening in the foreseeable future since the IMF program calls for strict management of domestic credit; the upper limit 

- 63 -

on monetary growth and the lower limit on net international reserves must be observed.  Furthermore, new directives for boosting the capital adequacy of commercial banks to satisfy the 8 percent BIS equity ratio will force banks to continue managing their assets conservatively in times of heightened default risks. The three- year corporate bond yield should move in the range of 20～23 percent during the first half and average around 19~20 percent for the year, assuming an average won/dollar exchange rate for the year of 1,350～1,450.  If a departure from the baseline forecast on the exchange rate occurs, interest rates could easily shoot up to 30 percent, with lingering effects on capital expenditures.

It is possible that interest rates could begin to edge downwards in the second half when the increases in prices finally begin to moderate as a consequence of the contractionary monetary policy.  When stability returns to the foreign exchange market, we can expect a substantial decline in interest rates, helped by lower risk- premiums.  The quarterly projection for interest rates is based on forecast models; there will likely be a gradual decline in interest rates occurring through the third quarter as risk premiums are reduced.  The three- year corporate bond yield could conceivably approach 10 percent toward the end of the year if the won/dollar exchange rate actually does become stable and the prospects for a speedy recovery from the current turmoil improve. 

<Table Ⅲ- 15>            Granger Causality Test

Before Kia's near- bankruptcy                After Kia's near- bankruptcy

Notes: **,* given null- hypothesis, F- Statistic is significant at the 5% and 10% significance level.

- 64 -

The problem of debt overhang could be serious if the contractionary monetary policy fails to stabilize the currency very soon.  The economic costs are estimated to be quite phenomenal.  Another destabilizing factor is the Southeast Asian currency crisis; it remains a major question mark and will pose a threat to Korea's situation for some time.  The prospects for interest rate stability are not very good in light of the great uncertainty in the economic environment, especially with regard to the potential economic and social costs of the contractionary monetary stance and the deterioration of the global economy.  The interest rate movements will be largely influenced by developments in the foreign exchange market, which will in turn be contingent on domestic developments as well as how the crisis in Southeast Asia unfolds.

The longer- term prospects for interest rates are better.  The exchange rate will continue to be determined by the level of expenditures and the volume of Korea's total external debt burden.  The so- called Tequila effect of the Mexican crisis reminds us of the fact that changes in the level of liquidity should be carefully monitored by the market participants lest lax lending may lead to an increase in debt burdens and reduced potential for future growth.  It is also obvious that for the next several years, Korea's enormous debt burden will drag down economic growth and give rise to greater interest rate volatility.  To avoid the debt overhang problem, such as that experienced by Latin American countries in the 1980s, the structural adjustment effort must be expedited in order to improve solvency and debt servicing capacity.  Unless the exchange rate stabilizes gradually over the medium- term, Korea may also realize a lost decade of development, just like many Latin American had in the 1980s; the increased debt payments can easily prevent Korea from establishing a foundation for further economic growth.

Interest rate forecasting in this time of crises is a vary tenuous task with enormous standard errors.  This renders exchange rate stability of even greater importance in the short run as is would narrow the future path that interest rates could take.  Again, Korea's efforts to correct old problems should start with maintaining economic stability, and this hinges almost entirely on stabilizing the 

- 65 -

exchange rate.

<Table Ⅲ- 16>          Interest Rate Forecasts¹⁾

Notes:  1) End of quarter

- 66 -

Financial Market Developments

Banking

Deposit Market

The total volume of bank deposits held by deposit money banks, which includes deposits in won, sales of marketable financial products, and foreign currency deposits, rose by 17.6 percent in 1997, ending the year at 233.2 trillion won.  This was a slightly higher growth rate than in 1996, and much of it occurred in time and saving deposits; they swelled mainly as a result of the enormous influx of funds into the new MMDAs (money market deposit accounts) and short- term time deposits.  Sales of marketable financial products such as RPs and cover bills (bills based on commercial and trade bills) were up sharply as well, although the volumes of CDs and demand deposits fell as the recession became more and more prolonged.  There was also a remarkable increase in foreign currency deposits; many residents rushed to change won into dollars in order to hedge against the Korean won's sharp depreciation, especially towards the end of the year amidst the financial turmoil.  The interest rates on bank deposits rose largely due to the surge in the market interest rates and the banks' increased efforts to attract depositors by offering high- interest yielding financial products. Troubled banks were especially aggressive in this regard.  The competition in the banking industry became quite intense, and depositors responded favorably, rushing in droves to take advantage of the rising interest rates; vast volumes of funds shifted between the various types of financial products available.

There were some bank runs on troubled banks after Korea approached the IMF for a bailout package to resolve the nation's financial and foreign currency crisis. These bank runs thankfully did not prove contagious, partly because of the bank restructuring plan which had been announced and the government's pledge to guarantee deposits.

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Demand deposits fell 16.1 percent to 21.2 trillion won during the year, more than reversing the 2.6 percent increase of the previous year.  There were several reasons for this: not only was there continuous movement of funds from demand deposits to high- interest yielding short- term products such as MMDAs made available after the fourth stage of interest rate deregulation took effect, but firms saw their retail sales contract, and banks reined in their commercial lending due to the financial instability.

Time and savings deposits at deposit money banks rose by 18.6 percent, reaching 162.9 trillion won by year- end.  The volume of time deposits alone soared by 41.8 percent.  These increases were due to deregulation of interest rates and the introduction of the new MMDAs in addition to the instability experienced by merchant banks and non- banking financial institutions.  The operations of 14 of the nation's 30 merchant banks were suspended in November.  This and other such problems prompted a large and continuing flow of funds from accounts at these financial institutions, such as CMAs at merchant banks and MMFs at investment trust companies, to high- interest yielding and relatively safe savings accounts at banks.  These flows were further encouraged by the banks' aggressive marketing efforts to attract more funds from other financial institutions into MMDAs when the fourth round of interest rate liberalization was completed and into time deposits after the agreement on the IMF bailout program was settled.  What is more, a large part of the money already invested in demand deposits and other time and savings deposits was reinvested in MMDAs since the latter were liquid and offered higher interest rates. 

<Table 1>                    Bank Deposits¹⁾

(billion won, percent)

- 68 -

The volume of mutual installment savings deposits peaked in the third quarter and then declined; the high- interest yielding products temporarily offered during the second half of 1996 began to mature at that time, and depositers shifted the funds from them into other short- term products which had even higher yields. Installment savings deposits rebounded from their decline in 1996, and the growth in tax- exempt long- term deposits decelerated because only one account could be opened per household.

Sales of negotiable certificates of deposits (CDs) declined considerably in 1997 after having increased in 1996, and sales of repurchase agreements (RPs), which 

- 69 -

carry no reserve requirements, exploded; they absorbed much of the funds that had been previously invested in CDs.  Sales of cover bills, which had risen 55.9 percent in 1996, began to decline in the second quater of 1997 due to the shortage in underlying bills (commercial and trade bills), even though the limits on the issuance and maturities of CDs and cover bills had been abolished during the fourth stage of interest rate deregulation.

<Table 2>              Time and Savings Deposits¹⁾

(billion won, percent)

- 70 -

Foreign currency deposits exploded by 274.6 percent, largely due to the great increase in domestic residents' holdings of foreign deposits.  Many resident's rushed to retain the value of their savings in the face of the won's depreciation by opening foreign currency account.  This, in turn, created even greater expectations of further won depreciation, prompting many firms to retain their foreign deposits without converting them into won.  This was especially true in the late third quarter and the fourth quarter.  The won's slide had begun early in the year and continued as one major business group after another declared bankruptcy or nearly went bankrupt, and it lost value at greatly accelerated pace when the contagion of the Southeast Asian currency crisis affected Korea.  Non- residents' deposits in foreign currencies also rose: as a result of the meltdown of the stockmarket, investment trust companies increasingly held non- residents' deposits in foreign currency- denominated beneficiary certificates.

The market interest rates had been relatively stable through the second quarter but then began moving up in the third quarter.  They surged to over 20 percent November, when the financial and foreign currency turmoil hit with full force. Financial institutions, especially the most troubled ones, desparately tried to attract more deposits from customers by offering interest rates in excess of 20 percent. The situation became worse after Korea accepted the IMF reform program; one of the conditionalities of the IMF bailout loan package was that Korea raise interest rates to 20 or even 30 percent in order to stabilize the plunging local currency and money market.  The three- year corporate bond yield surged to 24.32 percent at the end of December, and the call rates rose even more sharply, reflecting the increased corporate credit risks and the downgrading of some financial institutions' credit ratings.  Henceforth, deposits interest rates have risen in general: financial institutions became locked in intense competition to attract depositors, but the high interest rates they offered greatly eroded their profits.  They also charged high lending rates to firms, thereby exacerbating the credit crunch.

<Table 3>        Interest Rates on Selected Bank Deposits¹⁾

(percent)

- 71 -

In 1998, the total volume of bank deposits is forecast to rise 16.3 percent to 271.2 trillion won, a somewhat lower rate of increase than that in 1997.  Deposits in won are expected to increase by 12.2 percent, thus continuing to push up the volume of time and savings deposits.  The volume of marketable financial products is forecast to rise at a rapid rate of 22.0 percent; the volume of RPs should rise very steeply, dwarfing the expected decline in CDs and the slight change in cover bills.  The growth in foreign deposits is expected to decelerate to 98.9 percent from 274.6 percent in 1997 because the domestic financial market is going to be open fully and the foreign exchange market stabilized.

These forecasts are based on several assumptions, the most important one being that, in accordance with the IMF adjustment program, the government will faithfully pursue financial sector restructuring and reform.  This will give rise to constant shifting of funds between financial institutions and financial assets during much of the year: there will be an especially great flow of funds into high yielding bank deposits as they are considered relatively safe and profitable compared to other savings instruments.  These forecasts also duly take into account 

- 72 -

the indirect contractionary effects that the IMF adjustment program will have on deposits; the growth in deposits will certainly be dampened as personal incomes fall as a result of the extreme slowdown in economic growth, the tight monetary and fiscal policy, and the reform of the labor market.  It should also be noted that neither investment nor the stock market will likely recover so strongly that the spare funds of households and firms will be absorbed into deposit money banks in any significant volume.  However, the volume of foreign currency deposits should rise strongly, though not as quickly as in 1997, because the full- blown opening of the financial market and the liberalization of the interest rates on foreign- currency savings deposits will allow banks to attract foreign currency deposits at home and abroad, including deposits from overseas Korean residents and operating companies.

- 73 -

Loan Market

The total volume of bank credits offered by deposit money banks, including loans in won, loans in foreign currencies, and loan guarantees and acceptances, is estimated to have risen to 295.3 trillion won in 1997, an increase of 14.7 percent, somewhat less rapidly than the 17.3 percent increase recorded in 1996.  Most of the increase came in loans, which represented 81 percent of total bank credits. Total loans increased by 19.3 percent to 238.9 trillion won; loans in won increased by 12.9 percent, led by a large increase in overdrafts and general loans, and loans in foreign currencies increased by 68.5 percent as depositors sought a safe haven from the instability in the foreign exchange market.  Guarantees and acceptances declined as banks were reluctant during much of the year to extend any kind of credit to the corporate sector. 

The slowdown in growth in bank credits in 1997 was partly due to the banks' efforts to meet the 8 percent capital adequacy ratio required by the Bank for International Settlements (BIS) and partly due to their fears of another series of corporate bankruptcies towards the end of the year.  The banks were under great pressure to meet the BIS ratio, and the risks of corporate default rose greatly. The banks therefore largely refused to extend new corporate loans, called in many existing corporate loans, and refused to purchase trade bills and to extend the maturities on commercial bills.  The banks were especially reluctant to lend to large- sized firms in order to avoid incurring even higher burdens of bad loans, and in some cases, were legally required to refuse loans to large firms because aggregate credit ceilings had been imposed on entire business groups.  The banks actually created a major credit crunch, pushing a number of firms into extreme financial difficulties.  The financial situation became even worse when the Bank of Korea assumed a tight monetary stance, one of the conditionalities of the IMF reform program.  The growth in banks credits was also reduced because banks sought to extend more loans to households and financially sound small and medium- sized firms.  This was consistent with the Bank of Korea's tight monetary 

- 74 -

policy.

<Table 4>                      Bank Loans¹⁾

(billion won, percent)

The volume of bills discounted fell slighly by 1.1 percent to 24.4 trillion won in 1997.  Trading in bills was down due to the continuing business recession as well as banks' reluctance to discount bills out of fears of further corporate 

- 75 -

bankruptcies. 

The volume of overdrafts soared 51.7 percent, completely reversing the slight decline in the previous year, and amounted to 11.8 trillion won.  Many firms which were not able to issue commercial bills during those periods of the year when the credit crunch was at its worst- - after high profile bankruptcies such as Hanbo and after the Kia debacle- - were forced to resort to overdrafts as an alternative means of raising short- term operating funds. 

General loans in 1997 recorded a comparatively sound growth rate of 16.2 percent, rising to 105.4 trillion won by year end.  The volume of general loans rose at a stable rate until the end of July, when some large- sized firms borrowed large sums of money from deposit money banks before the scheduled imposition of the aggregate credit ceilings on single business groups.  According to the new regulations, no bank may grant loans to any single business group in excess of 45 percent of that group's equity capital.  The amount of lending to any group in excess of that limit is to be paid off over the next three years.  General loans also increased due to banks' efforts to extend more loans to households and to financially sound small and medium- sized firms.  The increase in loans to these entities more than offset the reduction in lending to large- sized firms.  The Bank of Korea's financial support to large groups according to the Anti- Bankruptcy Accord contributed to the rise in general loans as well.

The volume of loans in foreign currencies, which are mainly used for corporate investment in facilities, is estimated to have risen to 38.8 trillion won in 1997, a strong increase of 68.5 percent from the previous year.  Many firms experienced difficulties in obtaining overseas financing and therefore had to rely increasingly on loans in foreign currencies at domestic banks in order to repay the principal and interest on their overseas borrowings.

<Table 5>             Loans with Banking Funds¹⁾

(billion won, percent)

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Loan guarantees and acceptances fell by 1.3 percent from the preceding year. Banks tightened the eligibility requirements for them partly because they expected a series of bankruptcies of large- sized firms to occur and partly because the new BIS guideline on risk- based capital ratio imposes a 100 percent risk weight on loan guarantees and acceptances.

The interest rates on bank loans, especially those on overdrafts, rose sharply at the end of the year because of the rising market interest rates and financial market turmoil as well as the tightness in monetary policy.  Banks actually forced the lending rates up even further as they strove to rescue themselves: awash in nonperforming loans, holding under- valued securities, and facing difficulties in obtaining overseas financing, many banks were in desperate straits and had no choice but to jack up interest rates.

The 26 commercial banks collectively recorded their worst- ever performance in 

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1997, posting a combined net loss of 3.9 trillion won.  They incurred heavy losses due to bad loans and poorly performing stock investments.  This was in marked contrast to their performance in 1996, when they realized a total combined net profit of 0.9 trillion won.  In 1997, the banks' suffered snowballing losses from a flood of bad loans in the wake of a series of bankruptcies of large firms starting with the Hanbo group.  The stock market meltdown dealt them a further blow. The major problem, however, at most banks was really a woeful lack of risk management expertise.  Many of their losses would not have been incurred had they properly analyzed and managed their credit risks.

<Table 6>        Interest Rates on Selected Bank Loans¹⁾

(percent)

For several reasons, the total volume of bank credits in 1998 is forecast to rise by 10.8 percent to 327.2 trillion, a slow rate of growth compared with that of the previous year.  Despite the strenuous efforts of the government to overcome the severe financial crisis, banks will be very cautious in lending and will reduce the risk- weighted assets to meet the BIS capital adequacy ratio of 8 percent.  Banks which fail to meet the capital adequacy ratio will have to formulate and implement drastic self- rescue plans to weather their financial difficulties.  Corporate demand for equipment loans is not likely to rebound significantly since firms have no 

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incentive to expand facilities as long as the domestic business remains stagnant, although their demand for operating funds will not decline so much.  Credits to large- sized firms are not expected to increase largely because of the imposition of stricter eligibility requirements and banks' more careful credit analysis of entire business groups.  Moreover, various measures by the government will further reduce the volume of loans to large- sized firms.  The imposition of aggregate credit ceilings on all business groups, the abolition of cross- debt guarantees among the affiliates, and other such practices will preclude a great deal of additional lending.  Finally, with the full- blown financial market opening, banks will be encounter more severe competition.

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Bank Trust Market

At the end of 1997, the total volume of trust accounts at deposit money banks is estimated to have risen to 174.7 trillion won, a 15.6 percent increase from the previous year.  Despite the continuing inflow of funds into specific trusts, tax- exempt trusts, and personal pension trusts, the volume of money- in- trusts did not increase so much as during the previous year because of the reduced inflow 

<Table 7>                    Trust Accounts¹⁾

(billion won, percent)

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of funds into corporate trusts, household trusts, and retirement pension trusts.  The 

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newly introduced installment trusts were very popular and attracted a large volume of funds from accounts at non- banking financial institutions and bank deposits because they were very liquid and offered yields of more than 20 percent.

The total volume of household trusts fell 25.3 percent, a great decline compared with the previous year.  Although the transaction fees charged on them have been reduced and their yields had not fallen so much, many account holders transferred their funds into the newly introduced installment trusts, which offered greater liquidity and higher yields.  The volume of corporate trusts fell even more drastically, by 37.4 percent, primarily due to the persistent outflow of short- term funds from bank trust accounts into savings deposits such as MMDAs.  The yields on these trusts were relatively low, a reflection of their ample liquidity.  The volume of nonspecific trusts increased by 8.2 percent, a slower rate of increase than during the preceding year.  The government has tried to reduce the volume of general nonspecific trusts with fixed returns, and the newly introduced MMDAs were so popular with customers that they took little notice of the existing installment trusts.  The volume of development trusts plummeted because they could not offer competitive yields and the issuance limit on them had almost been reached. 

The volume of specific trusts showed high growth during the year, rising to 44.9 trillion won.  The yields on specific trusts are competitive because they are determined by the rates of return on the investments that are specified by the trust investors, and there are few restrictions on their asset management.  Institutional investors including insurance companies therefore invested in specific trusts a large part of their funds that had become available from expired nonspecific trusts.  The volume of tax- exempt trusts also showed rapid growth, reaching 7.5 trillion won. Among them, both tax- exempt household trusts, which had been introduced in the fourth quarter of 1996, and tax- exempt workers' trusts, introduced in the fourth quarter of 1997, were especially popular.  Personal pension trusts grew steadily because the banks began to offer a wider range of financial services to non- corporate customers. 

The new types of installment trusts were introduced to counter the financial 

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jitters arising from the suspensions of troubled merchant banks in December 1997. They were well received on the market and actually took in 17 trillion won in only the last two weeks of 1997.  They were expected to benefit investors by offering both high liquidity and high yields, and to benefit banks by allowing them to discount and deal in commerical paper (CP), thereby compensating them for the shortage in bank credits.

The volume of money- in- trusts is expected to rise by 25.8 percent to 219.7 trillion won by the end of 1998.  This would be an even higher rate than that recorded in 1997.  It is expected that a large volume of funds from merchant banking corporations, investment trust companies, and other non- banking financial companies which had been closed down or are now under restructuring may flow into the banking sector, especially into bank trusts accounts.  The bank trust accounts are not subject to either reserve requirements or BIS prudential regulation, at least on the balance sheet.

The volume of personal pension trusts, tax- exempt trusts, and retirement pension trusts will show relatively sound growth.  The needs for personal pensions will be sustained since the Supreme Court recently ruled that payment of retirement allowances prior to payment of other liabilities was unconstitutional, and the tax- exempt trusts will be attractive because the capital gains tax rates had been increased in the fourth quarter of 1997.  Furthermore, it is expected that competition between banks and non- banking financial institutions will intensify as all of these institutions strive to preempt the corporate retirement pensions (trusts) market before it opens in 1998.  The growth in newly introduced installment trusts will likely decline in the second half of 1998 as a result of imposition of government regulations on their high yields, low fees for early termination, and short maturities.

Banks are expected to manage their assets conservatively in 1998, just as they did during the previous year.  That is, banks would prefer to extend more high- return and low- risk household loans and other such loans, extend corporate loans only to the most financially sound firms, and limit their purchases of CP and of the loan guarantees on CP.  The volume of loans to financially sound small and medium- sized 

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firms is expected to rise because the loan market will likely remain highly segmented and because the government is strongly encouraging financial institutions to make loans to such firms.

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

(billion won, percent)

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Non- bank Financial Institutions

Overview

In 1997, the total volume of deposits at non- bank financial institutions (NBFIs) grew at much lower rate than during the previous year, rising only 13.7 percent. The total volume is estimated to have amounted to 303 trillion won. The total volume of deposits at Merchant Banking Corporations (MBCs) continued to fall due to the implementation of the Fourth Stage Interest Liberalization Plan and the MBCs' own financial crises. The sales of Commercial Papers (CPs) at MBCs fell sharply, but the issuance of own paper and volume of CMAs rose slightly. The total volume of deposits at Investment and Trust Companies (ITCs) continued to increase due to strong demand for short- term bond funds. However, Mutual Savings and Finance Companies (MSFCs) continued to experience anemic growth in total deposits since the interest rate differential between their products and those offered by banks has declined significantly. Total deposits at Credit Union (CUs) and Community Credit Cooperatives (CCCs) slowed down relative to the previous year.

The rate of growth in total credits at NBFIs fell from 24.5 percent in 1996 to 2.6 percent in 1997. The NBFIs were extremely conservative in their lending, particularly to small-  and medium- sized firms in 1997, due to the financial turmoil sparked by the continued bankruptcies of industrial conglomerates. Since investors' demand for corporate bonds and stocks were low, many firms attempted to meet their need for working capitals by issuing CPs. However, total credits at MBCs declined because of sharp fall in paper discounting, which constituted the largest portion of the total credit and factoring. Total credits at regional financial institutions, such as Mutual Savings and Finance Companies (MSFCs) and Mutual Credits (MCs), showed sluggish growth since they were also very concerned about the increasing default risk of small-  and medium- sized firms.

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<Table 9>            Deposits and Credits at NBFIs¹⁾

(billion won, percent)