Economic Growth Controlling Capital: focusing on the 1960s’ experience in Korea
Kang-Kook Lee (Ritsumeikan University)
Abstract
The political economy of capital controls, liberalization and crisis in Korea are examined from institutional and historical perspectives. We analyze how capital controls helped economic growth under the developmental state. The experience with capital controls in Korea points to the importance of the specific institutional structure for success. We then examine the process of the demise of the developmental state and the mismanaged process financial liberalization and financial opening. We describe the change in the financial system and the government-business relationships. The broad change of institutions and liberalization led to serious vulnerability in the economic system and the financial crisis. After the crisis, the government introduced further opening as part of neoliberal economic restructuring. This raises concerns of foreign dominance, lower investment and higher instability. The Korean experience demonstrates that it is essential to consider the broad issues of political economy in order to understand the effectiveness of and changes in capital account regimes.
Key Words: Capital Controls, Capital Account Liberalization, Financial Crisis, Economic Restructuring, Korea
JEL Classification: O16, O53, P45
I. Introduction
The Korean economy was awe to economists in many ways. It was applauded as an economic miracle for its great economic growth. Thus, there have been lots of studies on this success. Recently the 1997 economic crisis triggered another hot debate about the cause of the Korean economy. In understanding the Korean success and crisis, it is very important to study the foreign capital management policy. The miraculous growth was based on the strong capital controls, and the crisis was mainly due to the careless financial opening policy.
In this study, we examine the Korean experience of the foreign capital management policy in the 60s’. In fact, the dominant mainstream argument is that liberalization and opening of the market provides the economic success and the liberalization is recommended to all over the world. However, it is not clear about the financial market. Still most empirical studies report that there is no evidence that capital account liberalization spurs growth in developing countries. Rather, capital account liberalization tends to cause instability and in some cases, capital controls may help economic development like in Korea. Thus, more extensive study about the case of capital controls, in particular about how it can be helpful to the economy, is called on. In this regard, the Korean experience of capital management is very interesting. Based on the specific institutional structure of developmental state, the government successfully implemented the controls as one of important part of the development strategy.
This paper consists of 4 parts. In the first section, we examine the current arguments about capital controls, we review the mainstream and heterodox arguments and show how capital controls may help growth under some conditions called the developmental state. The next section deals with the institutional structure of the developmental state such as the specific government-business relation and state-led financial system. We examine the experience of foreign capital management in Korea in the third section. The strong capital control regime was established as early as in the 60s’ and continued up to late 80s’, however the government was also active to encourage foreign borrowing with its guarantee. We study how specific institutional structures and political economy are interrelated with the successful controls in the 60s’ in Korea. Also, we shed important light on how the controls are related to other policies such as the industrial policy and domestic financial controls for economic development. In so doing, we can get important lessons of the capital controls policy for other developing countries.
II. Political economy of capital controls, decontrol and economic development
1. Capital account liberalization, controls and economic development
(1) Pros and cons of capital account liberalization and controls
Mainstream economists emphasize gains from the international capital movements made possible by capital account liberalization; their arguments are base on belief in efficient markets.[1] They argue that the integrated global financial market enhances efficiency in resource allocation, reduces the costs of intertemporal misalignments and helps investors diversify risks. They also maintain that liberalization and international capital movement increase the availability of foreign savings to supplement domestic capital in the host country, and thereby encourage investment (Guitian, 1997; Edwards ed., 1995; Prasad et al., 2003). In addition, the international capital market disciplines national governments and liberalization reduces budget deficits (Kim, 2003). According to these arguments, capital controls limit the opportunities afforded by the international market, restrict financial market competition, and introduce distortions and inefficiency (Dornbush, 1998). They are both inefficient and ineffective because in most cases private capital can evade these controls (Edwards, 1999).
However, these arguments are valid only with the assumption of an ‘efficient’ financial market. It is hard to support efficiency of markets either theoretically or empirically. Financial markets suffer from serious market failures due to information problems, with investors displaying ‘herd’ behavior (Luxx, 1995; Kim and Wei, 1999), and they are rife with moral hazard problems, giving a rise to ‘overborrowing’ or ‘overlending’ (McKinnon and Pill, 1999). Furthermore, from the perspective of the ‘theory of the second best’, the benefit of liberalization is hard to justify coexisting trade barriers and differential tax rates (Brecher and Diaz-Alejandro, 1977; Bhagwati, 1998). Financial opening may generate more instability, aggravating boom-and-bust cycles and concentrating risk, rather than diversifying it. In fact, recent financial crises are explained by self-fulfilling expectations models with strong contagion effects transmitted through the international financial market (Eichengreen et al., 1997).
Faced with the critique that financial opening may destabilize the economy, economists point to the importance of several preconditions and proper sequencing for the success of liberalization (McKinnon, 1991; Williamson and Mahar, 1998). Successful capital account liberalization needs macroeconomic stability and the establishment of a sound financial sector with a strong supervision system, and it should be developed gradually, only after trade liberalization. This so-called ‘orderly financial opening’ rubric has become the new conventional wisdom (Eichengreen and Mussa, 1998; Fischer et al., 1998).[2] However, although these economists recognize the importance of regulation and institutional development, their main thrust is still toward liberalization. They underestimate problems of international financial markets and the limits of national regulation following opening. Setting up prudential regulation in developing countries takes years, and even developed countries with relatively good regulation suffer from crises (Rodrik, 1999). Moreover, it is not easy to distinguish between capital controls and prudential regulation since prudential regulation also limits the free capital movements. Hence, more skeptical views have prevailed recently. In particular, after the Asian crisis in 1997, many prominent economists have argued that the crisis was due to careless financial liberalization and opening, and called for controls over short-term capital flows (Furman and Stiglitz, 1998; Radelet and Sachs, 1998; Krugman, 1998). However, it should be noted that they remain focused on the volatility of short-term capital, and do not examine capital controls in the broader context of management of the economy and the development process.
To resolve this controversy, a large number of empirical studies have been done recently. They show only mixed results; there is no strong evidence that capital account liberalization spurs economic growth (Prasad et al., 2003).
(2) Capital controls, economic development and political economy
Heterodox economists understand capital controls and liberalization in relation to the broader context of economic management and growth. They argue that controls are helpful to implement full employment and egalitarian policies. National governments may lose policy autonomy under an open capital market because of the possibilities of capital outflow and currency attacks (Crotty, 1989). The ‘golden age’ of capitalism was based on capital controls that enabled the adoption of Keynesian macroeconomic management and the promotion of economic stability (Helleiner, 1994). Financial globalization, starting in the 1980s, has made it harder for countries seeking full employment to manage their economies, and has done harm to workers with a threat of capital outflows.
Heterodox economists argue that capital controls, if effectively adopted under a proper development strategy, can be an important tool to promote national economic development in developing countries. In particular, they emphasize political will and the feasibility of controls in practice (Crotty and Epstein, 1996).[3] Historically, developing countries have kept controls for various reasons, including avoiding balance of payments problems and ensuring macroeconomic stability (Johnston and Tamirisa, 1998). The experience of East Asian countries deserves special attention with regard to the important role of controls for growth. They achieved rapid development with strong capital controls that worked in conjunction with credit controls and national developmoent plans (Nembhard, 1996).
Proper capital controls may spur growth through several channels. First, controls can keep capital in the domestic economy and hinder capital flight, which can increase domestic savings and investment. Several African and Latin American countries have suffered from huge capital flight (Ndikumana and Boyce, 2002). One may argue that controls repress capital inflows that are necessary in the early stage of development, but this is not self-evident. For instance, selective controls may change the structure of foreign capital inflows towards longer term so as to encourage economic growth, as in the case of Chile. A proper management of foreign capital, such as guarantees for foreign debt, may encourage foreign capital inflows.[4] Foreign investment is indeed more affected by the country’s growth potential rather than by regulation itself (Mody and Murshid, 2002). Capital controls are likely to maintain foreign reserves, allow for the manipulation of the terms of trade for trade growth, and, most importantly, stabilize the economy, thereby further boosting economic growth (Ramey and Ramey, 1995; Prasad, et al., 2003). Measures to regulate foreign direct investment (FDI) may be also needed for the growth of domestic firms and autonomous national development. Though FDI is said to be more beneficial than other flows, some regulations are essential to reap the spillover effects and acquire advanced technology and modern management skills (Mardon, 1990).[5]
Of course mere controls are not a sufficient condition for growth; it is necessary that controls be incorporated in policies designed to promote productive investment. Thus, they should be coordinated with appropriate efforts by the state in capital allocation (Stiglitz, 1994).[6] While financial liberalization in developing countries usually fails to promote long-term investment and growth, effective financial control can achieve success, as seen in East Asia. (Dimitri and Cho, 1996; Hellman et al, 1997). Capital controls were an essential part of the state-led financial system that mobilized capital and allocated it into priority industries. However, financial and capital controls may hamper growth, unless rent-seeking and corruption are minimized in the process, as seen in the failure of intervention in other countries. In fact, the East Asian success was in large part due to an institutional structure called the developmental state (Evans, 1995; Louriax et al., 1997). We examine this specific context and political economy in which capital controls can be successful in the next section
2. Political economy of capital controls and decontrols
(1) Developmental states and capital controls
The institutional structure was crucial to economic growth in East Asia. Opposed to neoclassical arguments emphasizing free market operations (Balassa, 1988; World Bank, 1993), heterodox economists stress the important constructive role of the state. They point to several active government policies that were essential for the success of the region, including the selective promotion of industry, credit allocation programs, various trade protection measures, and capital controls (Amsden, 1989; Wade, 1990; Chang, 1994).
Specific institutional structures such as ‘embedded autonomy’ and high state capacity, along with a distinctive state-society relationship helped intervention succeed (Leftwitch, 1995; Evans, 1995; Ahrens, 1998). States in East Asia had strong autonomy and a large administrative capacity because no strong economic interest groups existed. A second important feature was the close and cooperative government-business relationship, and the discipline that states maintained over businesses. These mitigated information problems and limited rent-seeking (Weiss, 1998). Although not often considered, external threats and international geopolitics played an important role (Vartiainen, 1995). On this basis, the region developed a state-led financial system and developmental regime, combining market and state mechanisms in a unique way (Pempel, 1999). This system, which some have called ‘quasi internal organization’(QIO) included large enterprises and banks that operated with coordinating hierarchical relations based on financial control (Lee, 1992).[7] An outward-oriented strategy played a role since export performance provided criteria the government could use to support and discipline the corporate sector, while the government simultaneously introduced import substitution and protection.[8]
How do capital controls function under the developmental state, and what is the interaction between them? The effective execution of controls is only possible with significant government capacity and relatively little corruption. More importantly, the growth-oriented state encourages the corporate sector to make use of borrowed capital productively by enacting industrial policies and controlling domestic finance. Foreign capital was an important source of preferential policy credit to encourage priority investment (i.e. the ‘carrot and stick’ strategy of discipline and support) (Amsden, 1989). Hence, capital controls worked as an essential component of the developmental state.[9] Controls also helped the government discipline businesses because they relied on external finance and foreign capital, all of which were controlled by the government.
Developmental state theory helps us understand the importance of institutions for successful capital controls in this regard. However, the ‘relational’ nature of the state and the social influence on policies should be considered further. Important aspects of institutional change or evolution have not been studied until recently (Jessop, 2000; Chan et al., 1998; Cho and Kim, 1998).[10] Ironically, the success of the developmental state may engender its own demise as the growth of private businesses undermines state autonomy and international pressure to liberalize increases (Lee, 2004). The change of the developmental state and capital account regimes are another important issue that should be studied extensively.
2) Role of the government in financial market and capital controls