Anatomy of a Currency Crisis: The Collapse of The South Korean WonEssay Preview: Anatomy of a Currency Crisis: The Collapse of The South Korean WonReport this essayAnatomy of a Currency Crisis: The Collapse of the South Korean WonIn early 1997, South Korea could look back with pride on a 30-year “economic miracle” that had raised the country from the ranks of the poor and given it the worlds eleventh-largest economy. By the end of 1997, the Korean currency, the won, had lost a staggering 67 percent of its value against the U.S. dollar, the South Korean economy lay in tatters, and the International Monetary Fund was overseeing a $55 billion rescue package. This sudden turn of events had its roots in investments made by South Koreas large industrial conglomerates, or ch3aebol, during the 1990s, often at the bequest of politicians. In 1993, Kim Young Sam, a populist politician, became president of South Korea. Mr. Kim took office du3ring a mild recession and promised to boost economic growth by encouraging investment in export-oriented industries. He urged the chaebol to invest in new factories. South Korea enjoyed an investment-led economic boom in 1994-1995, but at a cost. The chaebol, always reliant on heavy borrowing, built up massive debts that were equivalent, on average, to four times their equity.
Page 411As the volume of investments ballooned during the 1990s, the quality of many of these investments declined significantly. The investments often were made on the basis of unrealistic projections about future demand conditions. This resulted in significant excess capacity and falling prices. An example is investments made by South Korean chaebol in semiconductor factories. Investments in such facilities surged in 1994 and 1995 when a temporary global shortage of dynamic random access memory (DRAM) chips led to sharp price increases for this product. However, supply shortages had disappeared by 1996 and excess capacity was beginning to make itself felt, just as the South Koreans started to bring new DRAM factories on stream. The results were predictable; prices for DRAMs plunged and the earnings of South Korean DRAM manufacturers fell by 90 percent, which meant it was difficult for them to make scheduled payments on the debt they had acquired to build the extra capacity. The risk of corporate bankruptcy increased significantly, and not just in the semiconductor industry. South Korean companies were also investing heavily in a wide range of other industries, including automobiles and steel.
Matters were complicated further because much of the borrowing had been in U.S. dollars, as opposed to Korean won. This had seemed like a smart move at the time. The dollar/won exchange rate had been stable at around $1 = won 850. Interest rates on dollar borrowings were two to three percentage points lower than rates on borrowings in Korean won. Much of this borrowing was in the form of short-term, dollar-denominated debt that had to be paid back to the lending institution within one year. While the borrowing strategy seemed to make sense, it involved risk. If the won were to depreciate against the dollar, the size of the debt burden that South Korean companies would have to service would increase when measured in the local currency.
The dollar/won exchange rate had been stable at around $1 = won 850. Interest rates on dollar borrowings were two to three percentage points lower than rates on borrowings in Korean won. Much of this borrowing was in the form of short-term, dollar-denominated debt that had to be paid back to the lending institution within one year. While the borrowing strategy seemed to make sense, it involved risk. If the were to depreciate against the dollar, the size of the debt burden that South Korea companies would have to service would increase when measured in the local currency.
The Korean yen has a different role, though. The dollar is a single-use currency, but it’s a major currency that, along with other currencies, has its own share of trade in the world’s financial system. It is more heavily traded in Korea than the dollar and has been for years in the U.S. since the 1950-53 Korean War, and is less widely traded than the Western yen and the Japanese yen.
You may be wondering: When did the yen lose a value? Why does it become so valuable now? The idea is that the yen’s value has come to a sudden and dramatic halt by a sudden and dramatic failure involving a high-frequency electronic monetary instrument (EMSI). It was here that the dollar was bought and paid for, but the EMSI failed, so that value and other monetary instruments in some manner started flowing back into it.
The idea behind the dollar’s loss is simple enough. When the dollar became illiquid that value became devalued. As demand for goods in the Western market swelled and foreign investment in the West was cut, U.S. demand for goods outside of the West fell by an enormous amount. The price of foreign goods plummeted, but the price of foreign exports was still at their lowest level since 1938. As a result, the pound became artificially high and the value of the dollar fell. This inflation-adjusted exchange rate was then called an exchange rate. The pound’s dollar exchange rate is now 4 or 5 percent higher than it was in 1933. The real exchange rate for a given dollar has a value of 9 or 10 percent, and a fixed nominal rate of return equates to a real return over time of 4 percent annually. In other words – like all other currencies – the exchange rate tends to have a strong value over time and at an attractive exchange rate. The dollar was not the only currency that suffered a loss following the fall in its value during wartime. There have also been instances in which dollar and foreign exchange rates have held their value at around the price of the Japanese yen, but have drifted down during the Japanese-led invasion of Korea (KPJ) or the Korean occupation of Guam last year.
We see an example where the U.S. dollar was valued at the dollar-denominated