Since the end of the Asian financial crisis, the Korean economy has bounced back strongly, albeit with the recovery punctuated by the credit card bubble of 2002-2003. Unfortunately, policymakers, scarred by the painful memories of these two crises, are once again on the wrong track. With fiscal policy too tight and the central bank raising interest rates, they run the risk of stifling domestic demand at a time when external conditions are set to worsen.
The 1997-1998 crisis was a painful one for Korea. The business sector, which had become hugely overleveraged, got crushed. Over the course of a year, corporate cash flow fell by 10 percent (profits even more), investment was slashed and many firms went bankrupt. Consumers also faced troubling times, as failing firms could no longer afford to pay their workers. A collapsing housing market only added to their woes.
However, the pain did not last long. Within a couple of years, the economy had regained much of the ground lost during the crisis. The government rightly followed IMF advice and focussed on sorting out the banking system. The corporate sector restructured vigorously. Balance sheets improved dramatically, profit growth picked up and debt servicing costs plummeted. Households were even quicker off the mark, as rising confidence and house price gains boosted consumption.
But the party was soon over. By 2002, the authorities were once again panicking as consumer credit growth ballooned. In their attempts to engineer a soft landing, their mistaken use of credit controls rather than interest rates cost them dear. A credit crunch ensued, causing huge increases in personal bankruptcies and repossessions, which stifled consumer spending for the next two years.
Since then output growth has accelerated, most prominently in the externally-orientated sectors. The household sector has been slow to get going, although recent rapid gains in house prices have offered a helping hand. Money and credit growth have increased, rising to levels not seen since the peak of the credit card bubble.
As a result, at each of its last two meetings the central bank, led by Governor Lee Seong-tae, decided to raise interest rates by 25 basis points, bringing them to 5 percent, their highest level since 2001. At the same time, the Bank of Korea (BOK) has also pushed up its discounted lending rates to small businesses, while continuing to stress its concerns over excess liquidity.