In an Uncertain World (34 page)

Once again, the core issue was how to reestablish confidence and stop the flood of capital out of the country. For an economy as large as South Korea's, this clearly would take a huge amount of money, as well as a serious policy commitment. The stakes were high, not just for South Korea but for the rest of the world. Many creditors and investors thought as follows: if mighty South Korea is going to default, how secure are loans and investments in other emerging-market countries? Banks, mutual funds, and hedge funds in the United States, Europe, and Japan that hadn't thought much about risk when times were good were already pulling back from developing countries without distinguishing among the circumstances. And there was no reason why this pullback would be limited to Asia. Latin America, Eastern Europe, and Russia were all in jeopardy. And if crisis spread throughout the developing world, the developed world could easily be pulled in as well.

This sort of contagion can involve a ripple effect, as the failure of one financial institution works its way through the system, causing an expanding number of other institutions to fail as a result. Financial linkages, though less broadly recognized than trade connections, are highly complex and diverse. Say, for instance, that Japanese banks were heavily exposed to South Korea. And say that U.S. commercial and investment banks had heavy exposure to Japanese banks. South Korea's troubles could feed back in unexpected ways to U.S. banks that had not considered themselves unduly exposed to South Korea.

In an extreme situation, the entire financial system could be threatened, with the health of the world's largest banking institutions at risk. But even without conditions growing that severe, major international lenders could become less willing or able to extend credit. If that happened, capital could quickly dry up, not only for the developing world but within developed countries as well. The potential existed for the whole international credit system to freeze, with untold consequences. In our discussions, we focused intently on the question of whether a failure in South Korea could trigger that kind of domino effect.

Over Thanksgiving, I was up at my house in Westchester County, where I was supposed to be spending a quiet holiday with Judy and my family. Instead, I spent much of the day and evening on a series of urgent conference calls with Treasury and Fed officials, the President, the national security advisor, and the Secretary of State. Madeleine Albright said she was basting a turkey while we talked about whether South Korea's financial problems could encourage a more aggressive military posture across the demilitarized zone to the North. At some point, we all took a break to eat dinner with our families before getting back on the phone.

For understandable reasons, we at Treasury and the foreign policy people in the administration looked at the issue from somewhat different perspectives. Madeleine and the other foreign policy advisers on the phone were mainly worried about our relationship with a crucially important military ally, as well as national security issues. They thought any instability in South Korea might encourage a reaction from the North, where troops had reportedly gone to some heightened state of alert. Their view was that we economic types were insufficiently focused on geopolitical concerns and that the United States needed to move quickly to show support for South Korea through the IMF and a backup loan from the ESF, as we had just done for Indonesia—what we were now calling a “second line of defense.” I felt strongly that if economic stability wasn't reestablished, our geopolitical goals wouldn't be accomplished either. Substantial money—from the United States and the IMF—had been a significant help in Mexico, but only in the context of the government adopting sensible policies. So far, the money we had pledged for Indonesia had not done much to mitigate the crisis there. Committing the IMF and ourselves to a show of financial support for South Korea without an adequate commitment to reform might even make it less likely that South Korea would get back on track, because providing money without strong conditions would reduce our leverage in getting the country to adopt a program that would work.

Late in the evening, I was still on the phone with the President and Sandy Berger. After speaking to South Korean President Kim Young Sam to strongly urge reform, Clinton, who was at Camp David, was waiting to be connected to the Japanese Prime Minister. President Clinton was supposed to urge Hashimoto to address Japan's problems and to discuss the South Korean problem more generally. But Hashimoto was on an airplane and couldn't be reached right away. As we waited and waited, some wondered if the Prime Minister didn't want to take this call. While we were standing by, Clinton was doing the
New York Times
crossword puzzle, which he reputedly could dispatch in a matter of minutes. He asked me about a clue—a three-letter word starting with some letter or other. I had no idea, so I asked my son Jamie.

“Who's so stupid that they don't know that?” Jamie retorted in a voice that could be heard at the other end of the phone.

“The President of the United States,” I said.

IMF Managing Director Michel Camdessus had already gone to South Korea once to begin negotiations. That trip had been made in secret to prevent spreading additional alarm. Now Camdessus was headed back to South Korea officially to negotiate the terms of an IMF program. Facing the prospect of a huge U.S. commitment to South Korea, we decided to send David Lipton to Seoul right away. We wanted to get an independent assessment of the situation as well as to reinforce the importance of strong reform measures.

Our view was increasingly that nothing short of a major reform program in South Korea would bring back market confidence. And more than in Mexico, the necessary policy changes needed to go beyond macroeconomic issues such as interest rates and exchange rates to encompass a range of structural issues that went to the heart of the South Korean economic system. One troubling practice was “directed lending,” whereby government officials could tell banks to whom to extend credit. That kind of arrangement was the lifeblood of what was being called “crony capitalism.” Korea also limited foreign investment and competition. The result of all this was that banks that had little discipline and that favored businesses were protected from failure and had virtually no financial constraints. South Korea would have to tackle fundamental issues for the economy to recover. But in negotiations with the IMF staff and direct discussions with David, officials of the Ministry of Finance and Economy offered inadequate proposals on key structural issues.

Our discussions within Treasury—about what South Korea needed to do to stop the crisis—continued almost around the clock. For many of these meetings, we relied on the Treasury telephone operators to connect us from disparate spots on the globe. During an intense phase of this discussion, I was in Chile at a meeting of Latin American finance ministers, David was in Seoul, in a completely different time zone, and Larry and others were in Washington. I remember placing a call from Chile to Michel Camdessus, who was under heavy pressure in Seoul to reach an agreement. The South Koreans kept announcing that they were about to sign a deal, perhaps trying to force the IMF's hand. We hoped that the South Korean intelligence service would be listening in, so my discussion with Michel—about the extreme importance of a strong program—was meant for the South Koreans as well.

As we continued to hold out, the South Koreans began to take the IMF conditions more seriously. They agreed that interest rates would be set at levels sufficient to restore a willingness to hold won-denominated assets. Directed lending would be abolished. Failed financial institutions would be closed or else restructured and sold. And South Korea's financial sector would open to competition, including from foreign companies. With these concessions in hand, Camdessus announced a $55 billion assistance package on December 3. This was the largest support program the IMF had ever assembled, although smaller relative to the size of the South Korean economy than the Mexican program had been.

Signing a deal didn't make us think South Korea's problems were solved—far from it. The big question was whether the commitments the government had made on paper would be implemented in practice and whether the markets would respond. The immediate reaction of the financial markets was positive, giving us initial cause for optimism. The South Korean won moved up a bit, and the South Korean stock market rose a good deal. But after two good days, the situation began to darken again. Beginning on Monday, December 8, the won plunged 10 percent a day for four days in a row—as much as it was allowed to move under the existing currency regime. That decline triggered a further downward spiral in other world markets, especially those in Asia.

What went wrong? One problem was that South Korea did not really want to let interest rates rise to the levels necessary to induce investors and creditors to stay. The government faced a kind of Catch-22: higher interest rates threatened to hurt the over-indebted
chaebol
s and weaken the South Korean banks still further. But companies and banks would also be damaged if the won fell more against the dollar, pushing up the won value of their dollar debts. And that was likely to happen if interest rates were kept too low.

As the situation deteriorated, foreign banks became more desperate to pull out their money. None of them wanted to be the last ones in when there were no reserves left to pay them. We kept daily tabs on what we called “the drain,” or the rate of hard currency outflows from South Korea. We now knew that the South Korean central bank was depositing its hard-currency reserves in South Korean banks. These banks promptly used the dollars to repay foreign bank loans, so the central bank could not feasibly get the dollars back. In early December, even after drawing $5.5 billion from the IMF, South Korea's foreign currency reserves were down to around $9 billion, with a “drain rate” of $1 billion a day.

We also had a problem, as with Thailand, of belated disclosure. The revelation that South Korea's buffer of reserves was almost gone spooked the markets. Rumors began flying about the size of South Korea's foreign debt. One estimate put the total foreign debt coming due in the next year at $116 billion. That meant that even the huge IMF program couldn't save South Korea if confidence didn't return. Around that time, Barton Biggs, a well-respected Wall Street analyst, estimated that South Korea could run out of reserves by the end of the month.

An additional problem was that the South Korean elections were rapidly approaching. With the country's political leadership in flux, the markets were skeptical that the government would be able to take ownership of the IMF program. Although the IMF had gotten the three leading candidates for the South Korean presidency to sign on, none of them evinced much enthusiasm for the reform measures that President Kim Young Sam had agreed to. The front-runner in the campaign was Kim Dae-jung, a heroic former dissident and eventual winner of the Nobel Peace Prize, who had spent time on death row under the military dictatorship that fell in 1987. Kim was a trade-union populist who, despite an election manifesto that in some respects echoed the IMF program, said in one interview that if elected, he wanted to renegotiate the terms of South Korea's deal with the IMF.

On December 18, the day of the election, top Treasury and Federal Reserve officials met to address what we all viewed as the threat of an imminent collapse of the South Korean economy. Of the many, many discussions we had about the deepening financial storm in Asia, the dinner we had that night at the Jefferson Hotel stands out in my mind as a critical moment. During the evening, there were several calls from the White House to work on the wording of the message President Clinton would deliver in a congratulatory call to the apparently victorious Kim Dae-jung that night. The basic point we wanted Clinton to convey was that President Kim had a real opportunity to change the way his country did business—and that the consequences of not doing so could be very bleak indeed.

Over dinner, we all discussed the situation. Our first attempt at an intervention—the biggest package ever negotiated by the IMF, backed up with additional support from the United States and other nations—hadn't restored the confidence of foreign investors in the South Korean economy. South Korea was significantly larger than Thailand and Indonesia put together. If the South Korean government or banking sector failed to make its scheduled loan payments, contagion could spread quickly through other emerging markets in Asia, Eastern Europe, and Latin America. We were very focused on the risk to the global financial system and the possible consequences for the industrial countries, including the United States. Some people at the table tried to convey their sense of this with a somewhat hyperbolic reference to a “1930s scenario.”

Most of the discussion that night was about our remaining options, none of which was very promising. One alternative was to “let South Korea go” and somehow try to build a firebreak around it by supporting other countries. But no one thought this was likely to work. So we focused much of our effort on other ways to shore up confidence: accelerating the disbursement of IMF funds and putting together a stronger international aid package—with more upfront money from the United States and Europe—as backing for stronger reforms in South Korea. Larry Summers said that the IMF money should be disbursed aggressively to avoid a “Vietnam” situation—that is, a gradual escalation that didn't work. Because the problem was confidence, he felt that we needed, as we had in Mexico, something more akin to the famous Colin Powell Doctrine—a massive show of financial force.

But even the more robust support package we were considering seemed insufficient to restore confidence by itself. Dinner ended with a better understanding of various unpromising options, but without any clear decision about which way to go. At the end of the evening, Tim Geithner's pager transmitted the news that concern about the effects of Kim Dae-jung's election victory was driving the won down further. Markets had opened in Seoul, where it was already morning.