Wednesday, December 24, 2008

The Open Door and the Even Hand

Originally published in the Korea Times.

From the window on the Pyongui line, I caught my first glimpse of Pyongyang, and my first thought was how different this place was from Seoul. Even the train ride here was a far cry from the KTX I took from the APEC summit in Busan. I remember being struck by the sheer dynamism of the city as it celebrated, and was celebrated by, the global economy. The difference with Pyongyang could not be more apparent.

While North Korea chose to close its doors to the outside world, South Korea chose otherwise, and has become Asia's fourth largest economy. Yet as the U.S. financial crisis sends shockwaves in international capital markets, Iceland and Pakistan near sovereign default, and a looming global recession, openness now seems a liability: Korea faces weakening external demand, rising inflation due to import prices, and a liquidity crunch from foreign capital flight.

This is not the first time Korea has faced global economic instability. Ten years of post-crisis reforms have prepared it to weather the storm ahead. But how well has it learned the lessons of 1997?

A fundamental principle of international economics is the ``impossible trinity'': a country cannot have capital mobility, an independent monetary policy, and fixed exchange rates simultaneously. Many Asian countries learned this the hard way in 1997. Yet Korea is trying to have all three in 2008: the economy needs foreign investment, the central bank targets inflation, while the government has intervened in currency markets in both directions.

1997 taught us that successful currency intervention is extremely difficult. The global financial system is too complex for anyone to foresee, let alone manipulate. Government intervention not only drains foreign reserves, it also risks overcorrecting, bad timing, and having unintended consequences. It often does more harm than good.

Given the complexity of the global economy, countries that benefit from international trade and finance must also accept some vulnerability to forces beyond their control. Risk and reward are part and parcel of capitalism. Though we cannot eliminate this risk without unacceptable costs, we can manage risk by strengthening the domestic economy and institutions, preparing it to stand against the tide of the global business cycle.

Korea has prepared well. Early warning systems keep an eye on economic conditions, and its financial institutions are far more robust today: Although some banks have U.S. exposure, their credit ratings are unchanged. Conglomerates have undergone painful restructuring and emerged stronger: for example, Hynix, formed from Hyundai and LG's semiconductor businesses, was billions in debt after the dotcom crash. Now, it is the sixth largest semiconductor manufacturer.

Yet one variable has been neglected: Small and medium enterprises. 99 percent of businesses, 88 percent of employment and 50 percent of added value in Korea come from small and medium-sized enterprises (SMEs). But while conglomerates restructured, SMEs were protected by the government and never went through Schumpeter's ``creative destruction.'' SME restructuring was merely delayed, and many, which should have adjusted long ago, now face bankruptcy.

The government should help SMEs weather the crisis, but it should not allow this support to be abused. In 1997, leverage and derivatives were the problems. Then, conglomerates over-leveraged with short-term foreign-denominated debt, precipitating the crisis when creditors called. Now SMEs are over-leveraged, with trillions in losses from debt financing through Knock-In Knock-Out (KIKO) derivatives.

Forex options are appropriate for exporters hedging against currency appreciation, or importers against depreciation, but that is not how KIKO options were structured. Instead of covering the downside from currency volatility, KIKO gave firms unlimited downside with limited upside from currency stability ― the opposite of a hedging strategy. Some subscribers were domestic-oriented firms with no direct exposure to currency risk in the first place. It is unclear whether they understood the risks involved or the instrument they bought. If they did, KIKO was a highly speculative bet that the government would intervene to stabilize exchange rates ― it did ― and that it would do so effectively ― it did not. But with the bailout of KIKO losses, they effectively won the bet.

SMEs were not solely responsible: Banks, which sold KIKO contracts, now face a class action lawsuit. There is a clear conflict of interest between their fiduciary duty and sales desk, and their corporate governance needs review. Yet as the government bailout proceeds, it should avoid distorting the market by rewarding misconduct and mismanagement. If good firms are to succeed, we must allow weak firms to fail, and taxpayers should not bear the burden of someone else's bad decisions.

Risk management in the global economy requires leadership that knows its limitations, and can make the tough decisions to do what is necessary, even if it is politically costly. The open door needs an even hand that is fair to exporters, importers, consumers, investors, and taxpayers alike. Risk management is not easy, but there's only one alternative to the open door: Just look north.

No comments: