(UNTITLED)

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP86T01017R000606090006-4
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 7
• Document Creation Date: January 12, 2017
• Document Release Date: April 25, 2011
• Sequence Number: 6
• Publication Date: June 11, 1986
• Content Type: MEMO

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Central Intdligerxe Agency
11 June 1986
Summary
Since the early 1980s South Korea has moved to
liberalize its financial sector, taking steps to
attract additional capital, technology, and
management skills; allow the market to determine
interest rates; and expand the use of equity
markets. Foreign bankers in particular have found
increased opportunities to provide financial
services in trade and foreign exchange
transactions.
Seoul has moved cautiously, in part to avoid
shocking the private sector as banks and businesses
are weaned from government-directed, subsidized
credit. In addition, although the increased
involvement of foreign banks has helped the 'domestic
banking system mature through competition, the
contrast between growing profits of foreign banks
and the poor performance of their domestic
counterparts has exacerbated underlying xenophobic
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This memorandum was prepared byl Office of East
Asian Analysis. Information available as of 11 June 1986 was
used in its preparation. Comments and queries are welcome and
may be directed to the Chief, Korea Branch, Northeast Asia
Division, OEA,
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sentiments, especially anti-Americanism.
Nevertheless, we believe the South Korean Government
is committed to a financial liberalization program
that will strengthen the domestic economy by
encouraging more efficient mobilization of capital
and more equitable allocation of credit between
large conglomerates and small firms, as well as by
shrinkin the illegal curb market in loan funds.
Financial Liberalization
Seoul began loosening controls on the financial sector in
1982, in our view, because of a variety of international as well
as domestic considerations. On the foreign side, the South
Koreans appeared to be responding to pressure from foreign
bankers and protectionist measures against South Korean exports
produced with subsidized credit. In the domestic setting, the
government wanted to put a high priority on mobilizing domestic
savings and feared that without a, new policy, the scandals linked
to the illegal curb market could recur. Liberalization efforts
have varied from one financial market to another, 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.
Encouraging foreign investment in South 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 phase out corporate dependence on
subsidized bank loans.
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Easing Controls on Commercial Banks
A major target of the liberalization effort has been the
banking sector. Seoul is gradually reducing the Bank of Korea's
direct control over the day-to-day management of that sector,
relying instead on general guidelines and standards of
performance:
-- In early 1983, the Bank of Korea, the central banking
authority and formerly the majority stockholder in South
Korea's commercial banks, completed a nine-year
divestiture program.
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The government has replaced direct credit controls for
each bank with indirect measures modeled after those of
developed countries, including reserve requirements,
rediscount operations, and open market operations.
The Bank of Korea's Office of Bank Supervision and
Examination is now concentrating on monitoring the
financial performance of individual banks and has
lessened 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).
Despite the relaxation of central controls, government
influence over domestic banking remains extensive. Privately
held South Korean banks are in fact under' lightly veiled
management control by the government. The Ministry of Finance,
for example, selects the chief executive officer for each of
these banks. The Ministry also controls interest rates in order
to affect inflation and to avert the slower economic growth that
might result from higher, market-determined interest rates in
chronically credit-short domestic financial markets. Because the
market plays a limited role in setting interest rates, the
Finance Ministry must 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 banks would otherwise shun in favor
of the largest firms, which now receive over half of all bank
Seoul also continues to monitor credit flows to the largest
firms and to restrict them if they absorb too large a percentage
of total credit. The Finance? Ministry took such action against
South Korea's five largest firms in late 1984. Although Seoul
relaxed these controls in 1985, when economic growth slumped, the
government has put the conglomerates on notice that it will
reinstitute credit limitations once growth picks up.
Furthermore, Seoul has decreed that no person or firm can hold
more than 10 percent of the voting shares in a single bank, in
order to prevent concentration of domestic banks in a few
hands. The government fears that if it stops intervening, the
large business owners will quickly take over the banks and use
them as ready sources of cash with no questions asked, a
situation it views as politically dangerous.
The government has also been forced to keep its hand in the
domestic banking sector because many of the loans banks made at
its direction have gone sour. These bad loans amounted to about
$4.5 billion at the end of 1985, while equity in commercial banks
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was only $1.2 billion--technically a state of insolvency. Much
of this bad debt is traceable to losses on construction projects,
primarily in the Middle East. The Bank of Korea has assisted
commercial banks, absorbing the bad debts by extending loans to
these institutions at preferential rates. Commercial banks pay 3
percent for these loans, while collecting 11 percent from
borrowers. The profits are to be used to create a reserve to
cover bad loans. If the government continues to make the special
loans at this year's $560 million rate, however, it will take 45
years to make up the shortfall. Even if foreign lenders view the
government's rescue plans skeptically, collapse of the Kukje
group in February 1985--formerly South Korea' sixth largest
conglomerate--provided 4n opportunity for the government to
demonstrate direct support of the banking system, essentially
confirming foreign lenders' views that corporate debt is also
sovereign debt.
Foreign Bank Rules Eased
Liberalization of the banking sector has extended to foreign
banks, as Seoul's economic liberalizers have instituted new
regulations placing foreign banks on near-equal footing with
domestic banks in the public bond market and in the competition
for won-denominated deposits and lending to domestic firms.
Other changes allow foreign banks to enjoy domestic bank status
through joint ventures with South Korean partners.
Seoul took another step toward responding to foreign
bankers' demands for equal treatment in early 1985, when it
granted foreign banks access to the Bank of Korea's rediscount
facility for export support loans--with the qualification that
they provide at least 25 percent of such loans-to small- and
medium-size firms. Seoul has pledged to continue to improve
foreign bankers' access to the rediscount window. Foreign
bankers had cited their lack of access to the rediscount window--
which left them with a chronic shortage of won--as a key
constraint on their effort to expand business to domestic
firms.
As the government eases the restrictions on foreign banks
operating in South Korea, it is also curtailing certain
privileges enjoyed exclusively by foreigners. In gaining access
to rediscount windows, foreign banks were required to surrender
guaranteed profits and freedom from foreign exchange risk1on swap
transactions--advantages not available to domestic banks.
'Swap transactions occur when a foreign bank acquires currency
from its home office (usually in the form of a short-term loan)
that is converted into won at the Bank of Korea.
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Seoul has not addressed the contentious issues of foreign
bank capitalization and property ownership. Foreign bankers
cannot make large, single-borrower loans, open new branches, or
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.
Despite these restrictions, foreign banks have earned a good
return on their assets in South Korea for the past five years.
Profits in 1985 were 34-.8 percent more than the previous year,
according to the press. Last year US banks surpassed their South
Kor.ean rivals in business performance, largely as a result of
their understanding of international business practices, advanced
communication facilities, and up-to-date management procedures.
The fortunes of South Korean commercial banks, in contrast, have
declined, with profits last year down 46.1 percent from 1984. E
Although the foreign bank profits are reasonable by
international standards, many South Koreans consider the profits
excessive. Traditionally, banks hav-e been perceived as
instruments of the government with social responsibilities, not
merely as profit-making institutions. Radical students and labor
have attacked branches of the Bank of America and most recently
Koram, a joint venture between the Bank of America and a Korean
bank. According to the US Embassy, the latest round of anti-
Americanism directed against the banks is probably in reaction to
South Korean newspaper reports on the "high profits" of foreign
banks. The tone of the press articles suggested that the foreign
banks were somehow taking unfair advantage of the South
Koreans.
Seoul has taken a variety of steps to deal with the backlash
set off by strong foreign bank performance. Earlier this year,
for example, South Korean tax examiners launched the widest
ranging audit of foreign banks since President Chun took power in
1980. Nine of the 15 banks audited were American. The
government is undoubtedly trying to convey the message that it
will not allow foreign bankers to profit unduly at South Korean
expense. Moreover, continued depressed profits among domestic
banks may prompt Seoul to close the door to new foreign banks.
Strengthening the Non-Bank Sector
Seoul's financial liberalizers are also looking beyond the
commercial banking sector and have taken some small steps to
bolster the equity markets and install a more flexible interest
rate regime:
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The government is implementing a comprehensive
development plan for the Korean Stock Exchange, designed
to encourage South Korean firms to replace debt with
equity financing.
As of this year foreigners can for the first time invest
directly in South Korean firms through convertible bonds
floated in European exchanges. Small mutual fund-type
investment in the Korean Stock Exchange, but traded in
foreign exchanges, has been allowed since 1981.
The government has taken a few cautious steps to loosen
its control over interest rates--the key to a market-led
financial system. Before 1984, the Finance Ministry
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 limits imposed
by the Ministry. Bankers are now allowed to charge loan
rates that reflect the demand for credit and the
riskiness of the borrower, although even the most
creditworthy firms usually pay the highest limit on loan
rates because of scarce credit. 25X1
Outlook
We expect financial sector liberalization will continue in
fits and starts as Seoul attempts to nurture its nascent domestic
financial institutions and Seeks to attract foreign capital and
technology to this sector. The long-term prospects for movement
toward an international, market-based financial system are good.
The key argument of the liberalizers--namely that greater
reliance on market forces will benefit the South Korean economy--
is gaining wider acceptance within the bureaucracy. The current
Chun cabinet, for example, is heavily weighted with proponents of
liberalization, who have eased restrictions on direct foreign
investment and imports, in addition to opening the financial
sector.
The US factor will also encourage Seoul to stay the
course. Renewal of Generalized System of Preferences (GSP)
benefits--which the 1984 US Trade and Tariff Act links to
progress in economic liberalization--and the threat of stern US
trade measures, such as 301 actions, will prod opponents to
liberalization to give way.
Nonetheless, the government is clearly handicapped by the
weakness of the banking system compared with the impressive.
growth of other sectors in an increasingly complex--and
profitable--economy. Whereas the South Koreans have often balked
at taking steps to liberalize imports and investment for
political reasons, the beleaguered banking system offers genuine
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constraints. Progress on 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 economy.
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