(UNTITLED)

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T00287R001001110001-9
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 10
• Document Creation Date: January 12, 2017
• Document Release Date: September 22, 2010
• Sequence Number: 1
• Publication Date: December 27, 1984
• Content Type: MEMO

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4. J LJ/~ I
Central Intelligence Agency
DIRECTORATE OF INTELLIGENCE
27 December 1984
South Korea: Financial Secto-r Liberalization
g
k
credit between large conglomerates and small firms.
and a shririkinn. of the ille
al curb ..
Summary
South Korea's liberalization of its financial
sector is part of a broader effort to open its economy
that includes easing regulation of imports and direct
foreign investment. Economic policymakers are taking
deliberate steps to attract additional capital,
technology, and management skills, allow the market to
determine interest rates, and expand the use of equity
markets. Seoul recognizes that it must use caution to
avoid shocking the private sector as banks and
businesses are weaned from government-directed,
subsidized credit. Even so, foreign bankers in
particular will find increased opportunities to
provide financial services in trade and foreign
exchange transactions. We believe that the domestic
economy will be strengthened by a more efficient
mobilization of capital, more equitable allocation of
'See Appendix for an explanation of the curb market.
This memorandum was prepared by , Korea Branch,
Northeast Asia Division, Office of East Asian Analysis. Comments
and queries are welcome and may be addressed to Chief, Korea
Branch Information available as of 20 December 1984
has been incorporated.
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 Seoul, which has been loosening controls on the financial
sector since 1982, has accelerated the pace of change in the, last
year. This activity reflects, we believe, a growing concern with
scandals linked to the illegal curb market, renewed pressure from
foreign bankers, and protectionist measures being applied abroad
aaaintt Smith Korean exports produced with subsidized credit.
Liberalization efforts vary from one financial market to
another as do the prospects for future deregulation, but Seoul
has crafted its program to benefit .all sectors by:
-- Promoting competition in the financial system.
-- Reducing government intervention in the routine
management of financial institutions, particularly
commercial banks.
Inducing foreign investment in Korean financial
institutions by easing restrictions on joint-ventures
and according foreign and domestic banks equal
treatment.
-- Developing new savings and debt instruments to improve
bank liquidity and end ate dependence on
subsidized bank loans. cor or 25X1
Controls on Commercial Banks Loosened
Seoul is gradually reducing the'Bank of Korea (BOK) direct
control over the day-to-day management of the banking sector,
relying intead on general guidelines and standards of
performance. Under the aegis of the Ministry of Finance (MOF):
In early 1983, the BOK, the central banking authority
and formerly the majority stockholder in South Korea's
commercial banks, completed a nine year divestiture
program.
The government has replaced direct credit controls for
each bank with indirect measures modelled after those
of developed countries, including reserve requirements,
rediscount operations, and open market operations.
The BOK's Office of Bank Supervision and Examination is
now concentrating on monitoring the financial
performance of individual banks and has stopped its
micromanagement of bank personnel, organization, and
budgeting.
The government is phasing out its special financial
treatment of specific industries by eliminating
preferential interest rates and forced lending (that
is, loans dictated by government policy).
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Figure 1
Central Bank
Deposit
Money Banks
The Financial System in Korea
Commercial
Banks
Special Banks
-The Bank of Korea
'omestic Banks (17)
Foreign bank brancies (49)
Development (3)
1 institutions
Non-Monetary
Financial
Institutions
Savings
Institutions
Life Insuranc
1 Companies
(196)
(19)
Investment
1 Com anies (4 1 )
Securities Korea Stock Exchange
lc}Cccurities companies (2 5 )
Note: Figures in parentheses denote the number of institutions.
Source: The BOK.
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 firiiiro 2
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Flow of Funds in the South Korean Curb Market. '
BROKER
BANK
COMPENSATING BALANCE*
INTEREST PAYMENTS
LOAN PAYMENTS
LOANS AND DEPOSITS
* Compensating balances are loan funds left on deposit at a
"'f i-nancial institution that raise the cost of borrowing by forcing a firm
to borrow more than is necessary to simultaneously meet financing needs
and the comDensatina balances
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Government influence over the financial system remains
extensive. The Ministry of Finance, for example, controls
interest rates in order to affect inflation-and to avert the
slower economic growth that might result from higher, market
determined interest rates. A major result of this is a continual
credit shortage caused by low deposit rates that discourage
savings and a strong demand for loans spurred by below market
interest rates. In this situation, the absence of market forces
requires MOF to control the allocation of credit among sectors:
domestic banks must reserve a specified percentage of their
loanable funds for small- and medium-sized firms and other high-
risk borrowers -- groups bankers would otherwise shun in favor of
the largest firms. Foreign banks are not now subject to this
requirement but beginning in 1985 f hanks ion will a'- be
required to hold similar reserves. 25X1
Seoul al?s'o continues to monito credit flows to the largest
firms and to restrict them if they absorb too large a percentage
of total credit. MOF took such action against Korea's five
largest firms in late 1984. Furthermore, Seoul has decreed that
no more than 10 percent of the voting shares in a single bank can
be held by individual investors in order to prevent the est
conglomerates from controlling domestic banks. 25X1
We believe these regulations are necessary as a result of
the lack of market determined interest rates, the dominance of a
few large conglomerates, and the reliance of South Korean firms
on cheap debt -- a dependency encouraged by Seoul for almost
20 years to foster industrialization. The MOF's regulatory role
also recognizes that the banks and government agencies still do
not have experienced personnel who can manage loan portfolios
without BOK direction or the trained - "!lators to conduct
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Interest Rate Decontrol
The government has taken a few cautious steps to loosen its
control over interest rates -- the key to a'market-led financial
system -- but we believe prospects for a comprehensive decontrol
of interest rates soon dim. Prior to 1984, MOF maintained a
rigid schedule of loan and deposit interest rates which is now
making way for a more flexible system that allows rates to vary
within MOF imposed limits. Bankers are'now allowed to charge
loan rates that reflect the demand for credit and the riskiness
of the borrower, although at present even the most creditworthy
firms usually pay the-highest limit on loan rates because of
scarce credit. The complete decontrol in November 1984 of
interest rates in the call money market, the rate banks charge
other banks for loans, and in the unguaranteed bond market
underscore Seoul' rnmmirmant to financial sector
li-beralization.
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Proponents of interest rate liberalization -- located
primarily in the Economic Planning Board (EPB) and MOF -- have
favored higher market-set rates to attract funds to domestic
banks, to maintain the tight money policy considered essential to
price control, and to encourage fiscal responsibility in
corporate borrowers and bank lenders. Critics of the revisions
have cited increased interest costs to business, a potential
slowdown in the economy, and a blunting of South Korea's
competitive advantage in export markets as disincentives tha25X1
outweigh the advanta
es of thes
f
g
e re
orms.
Monetary authorities at the MOF have generally preferred to
open new types of financial institutions and to introduce new
financial instruments that pay higher interest rates rather than
to adjust the rates on existing products. In the early 1970s,
for instance, 'they created several nonmonetary financial
institutions such as short-term finance companies and mutual
savings banks that were allowed to offer higher interest rates.
That move was designed to attract curb market resources
(Appendix 1) and the new firms were the first authorized to offer
such innovations as commercial and industrial paper. Commercial
banks can now offer these products, as well a s new high-yie'A"- g
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certificates of deposit (CDs)
.
Despite the progress made, Seoul has not been responsive to
rapidly changing interest rate market signals and continues to
set rates in the largest credit markets. Moreover, interest
rates for savers, particularly small account holders, are
substantially below market levels. As a consequence, the curb
market still is more efficient at mobilizing savings than the
organized money market. Even so, we believe the freeing of
interest rates in important financial markets may accelerate if
the experimental call money market and unauaranteed bond rates
are not unusually high or volatile.
Foreign Bank Rules Eased
We believe that new regulations placing foreign banks on
near-equal footing with domestic banks in the competition for
won-denominated deposits and lending to domestic firms will help
alleviate criticism from overseas bankers. Nonetheless, a
variety of constraints on their role remain in effect, and
foreign banks argue that only equal treatment can encourage them
to provide new technology and management expertise, as well as to
offer the enhanced competition that promotes more efficient
banking operations in South Korea. Major areas of..foreign
bankers' concern have been addressed by changes that-put foreign
banks on the same footing as domestic banks in the public bond
market and allow them to enjoy domestic bank;;status through
joint-ventures with Korean partners. In 1985, the government
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also will give foreign banks access to the BOK rediscount window
for preexport financing, followed by provision of-,-:full _^__-.vilPnPs
Foreign bankers cite the lack of access to the rediscount
window as a. key constraint on their effort to expand business to
domestic firms. Although their access to the rediscount window.
will open new business opportunities -- essentially by relieving
their chronic shortage of won -- it will a so require them to
phase out the the use of swap transactions as the primary source
of won funds for foreign banks. Swap transactions currently
protect foreign banks from foreign exchange risks and guarantee
profits on funds from.home offices -- advantages not available to
Seoul has not yet addressed the contentious issues of'
foreign bank capitalization and property ownership. Foreign
bankers cannot make large, single-borrower loans, open new
branches, and provide high-profit, nonlending services on an
equal basis with domestic banks because of regulations?that
narrowly define their capital -- the basis for their lending
limits. Moreover,:the prohibition .against foreign banks holding
title to real estate and other property, including ships and
aircraft, denies their use of such collateral to secure loans.
Although Seoul's attention to several major problem areas
will make the investment climate even more attractive to foreign
bankers over the next few years, new areas of friction are
certain to arise as the financial community's activity expands.
Foreign bankers, for example, must still gain MOF approval to
enter newly opened markets, a process that is often lengthy
because regulations are not clearly spelled out. Moreover,
continued depressed profits among domestic banks may prompt Seoul
,25X1
2Loans to South Korean firms are typically made by discounting
commercial bills or promissory notes. The bank gives a business'
firma loan equal to the face value of the bill or note less an
interest charge. The bank then presents this bill or note to the
BOK which rediscounts a portion of its face value at an interest
rate that is currently 5 percert. The rediscounted note or bill
is a low interest loan to the, bank which then can make a new loan
with the proceeds at the official loan rate. 25X1
3Swap transactions occur when foreign banks acquire currenc from
their home office (usually in the form of a short-term loan that
i
s converted into won at the BOK.
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Equity Market Restrictions Relaxed
Seoul has drafted a comprehensive development plan for the
securities market to strengthen the Korea Stock Exchange
(KSE) . Government officials hope that a sophisticated
securities market will provide alternative corporate financing to
spur growth and attract foreign equity investment, thus reducing
foreign debt. Heretofore, the traditional reliance on
subsidized, government-directed loans that are less expensive
than equity or bond finanrinn has retarded the development of
Seoul has opened the KSE to foreign investment in several
measured steps. Two $15 million trust funds of KSE-listed stocks
were privately placed with foreign institutional investors in
1981. The Korea Fund, started in 1984 as foreigners' first
chance to participate in the Korean securities market, has been
well received. Plans are being discussed for a second fund. A
limited number of foreign investors will be allowed to purchase
shares directly in prescribed industries in 1986. Restrictions
on repatriation.of profits and on areas whprp reign investment
is-permitted will be lifted in 1988. 25X1
Seoul has encouraged the internationalization of the
securities market by allowing, on a reciprocal basis, foreign
securities dealers to open representative offices and, since
1983, o establish joint ventures.-with South Korean securities
firms. Korean securities firms overseas, which are strictly
controlled by the MOF, can only underwrite bonds of Korean firms,
but Seoul plans to lift restrictions on their bond market
activities in 1988. Koreans will be free to make investments in
foreign securities by the mid-1990s. liberalization is
scheduled to be completed.
The success of the Korea Fund coupled with the excellent
growth prospects for firms listed on the KSE augur well for
continued foreign interest in Korean securities. As these
markets become more international, the process will provide more
capital to spur the domestic growth-of South Korean firms and
enable them al resources for debt and equity
financing.
Japanese and Australian stock exchanges, respectively.
e4The market-value of stocks listed on the KSE in 1983 was
$4.5 billion compared with $450 billion and $60 billion, '-
in~f rmaltion services and cannot conduct securities transactions.
5Representative offices are authorized to provide only market
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economy.
Outlook
Financial sector liberalization will be slow and steady as
Seoul attempts to nurture its nascent domestic financial
institutions and seeks to attract foreign capital and technology
to this sector. We believe, however, that the long-term
prospects for movement toward an international, market-based
financial system are favorable. The key argument of the
liberalizers -- namely that greater reliance on market forces
will benefit the Korean economy -- is gaining wider acceptance
within the bureaucracy. The current Chun cabinet, for example,
is heavily weighted with proponents of liberalization who Dave
eased restrictions on direct foreign investment and imports in
addition to opening the financial sector. Nonetheless, the
process is certain to move in fits and starts because of
bureaucratic tension. Political,considerations, economic
conditions, and trading partner insistence on also
alter the pace of the liberalization process. 25X1
-- The pace of financial sector liberalization could
slacken if policy disputes exacerbate rifts within the
ranks-of the liberalizers. In January 1984, a proposal
by Finance Minister Kim Mahn-je to align interest rates
with the market was opposed by Deputy Prime Mj:nister
and EPB head Sin Pyong-hyon, delaying reform until
November. We believe that the liberalizers will
continue to have Chun's ear, but greater caution and
his belief that liberalization and the economy are
progressing may well curb its pace.
-- Progress on the reforms also will depend on attitudes
among businessmen, politicians, and the general public.
Greater reliance on market forces carries-a variety of
risks and uncertainties, and if economic conditions
deteriorate, criticism of government policy would put
heavy pressure on Seoul to retake control of the
The 1984 US Trade and Tariff Act is an important
impetus for accelerated financial sector liberalization
in South Korea. Generalized System of Preferences
(GSP) benefits are linked to progress in economic
liberalization and South Korean exports to the United
States could be sharply curtailed if these benefits
were withdrawn. The South Koreans are certain to
monitor carefully the US approach to implementaion of
the trade act's provisions. Meanwhile, Seoul will
probably argue for continued access to US'markets by
highlighting its "developing country" status as well as
its unique defense and security needs that demand a
prudent ec rpfnrM rogram to maintain
stability.
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brokers. The existence of the curb market is explained, in part,
by a lack of diversified financial instruments for savers and
borrowers and by a rigid system of interest rates that are a
in a dynamic economy such as that of South Korea.
APPENDIX: The Illegal Money Market in South Korea
The curb money market, which operates outside the formal
financial sector, provides an estimated 10 percent of total
domestic credit. Though not illegal in itself, nearly all curb
market transactions violate tax laws and are made by unlicensed
The curb market is a relatively simple system (figure 2) in
which a broker collects savings from households for loans to a
third party, usually a business firm looking for short-term
credit or, perhaps, to finance a wedding or holiday gift. Savers
receive higher than official interest rates with no tax liability
and borrowers are willing to pay high loan rates for scarce
capital. The official financial sector participates in the curb
market as el funds between curb market brokers and
borrowers.
South Korea's curb market is periodically rocked by scandals
that paralyze this important source of short-term financing for
primarily small- and medium-sized. industries. The illegal and
unregulated nature of the curb market requires a high reliance on
trust in the broker by savers and borrowers. A 1982 scandal
resulted from a loss of confidence in a major curb market broker
who blatantly displayed government connections, whereas a 1983
scandal was caused by the bankruptcy of a major curb market
borrower. These scandals have had only temporary effects on the
curb market whirh unds with renewed vigor once order is
restored.
The government has tolerated the curb market because. it
helps to ease the liquidity problems caused by its tight money
policies, but major scandals are prompting a harder line. The
recent liberalization of interest rates.and laws discouraging the
use of aliases which cloak curb market participants are moves
intended to dry up these urces ane'4 bolster the formal
financial sector. ~ 7
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