Financial systems and development

Box 9.2
Financial reform in Korea
Korea's heavily regulated financial system was a key terest rates rose, and growing numbers of highly ininstrument
in the government's industrial policy of the debted firms found it difficult to service their debts.
1960s and 1970s. Interest rates were controlled and The government swiftly reduced nominal interest
were kept low during most of this period. A substantial rates, but because inflation declined, real lending rates
proportion of bank credit-well above one-third-was stayed between 5 and 10 percent throughout the 1980s.
directed by the government to designated sectors. By By the mid-1980s Korea had established macroecothe
late 1970s, however, a growing consensus had nomic stability: the annual inflation rate fell to 2-3 peremerged
that this approach was retarding the growth cent, and the fiscal and current account deficits were
of the financial sector and preventing the efficient allo- eliminated. Industry undertook a major restructuring.
cation of resources. Confronted with a significant mac- The financial sector has grown rapidly in the 1980s,
roeconomic imbalance and slower economic growth, largely owing to the explosive expansion of nonbank
the government changed directions. institutions and securities markets and, to a lesser ex-
Stabilization, structural adjustment, and financial re- tent, to growth in the banking sector. The ratio of M3 to
form programs were all introduced in the early 1980s. GNP almost doubled between 1980 and 1987 (see Box
The government adopted several measures to encour- table 9.2). Building on this progress, the government
age cornpetition in the financial market. Nonbank insti- began the full liberalization of bank interest rates in late
tutions, which were relatively new and lightly regu- 1988. Most lending rates were freed at that time, allated,
were further deregulated, and barriers to entry though deposit rates are still controlled. The governwere
greatly relaxed. Additional foreign financial insti- ment also announced plans to open Korea's financial
tutions, including banks and life insurance companies, markets to further foreign participation.
were allowed to open branches. Commercial banks,
most of which had been owned by the government,
were privatized. The government eliminated its prefer- Box table 9.2 Korea's financial sector, 1980, 1984,
ential lending rates and did not introduce any new and 1987
directed credit programs. At the same time, the author- (percentage of GACP)
ities fostered greater competition among different sorts Indicator 1980 1984 1987
of financial institutions bv allowing them to offer a .
M2 34.2 37.2 41.3
wider range of services. M3 48.6 68.1 94.4
The loans of commercial banks, even after privatiza- Corporate bonds 4.5 8.0 10.2
G tion, continued to be closely monitored and super- Stock market capitalization 6.9 7.8 26.8
vised. The authorities continued to regulate the inter- Note: M2 is currency in cji.slasion plus demand, time, and savings
H
est rates of banks and nonbank institutions, but they deposits and residents' foreign currency deposits at the central bank
partially deregulated interest rates in the money and and deposit money banks. M3 is the sum of M2, deposits at nonmarkets.
Controls iecurities on capitalflowswerest bank financial institutions, debentures, commercial bills, and certifisecurities
markets. Controls on capital flows were cates ofdeposit.
maintained. When inflation started to decline, real in- Source: Bank of Korea and Ministry of Finance, Republic of Korea.
limited and gradual. In Indonesia the major banks Latin American countries, other than those of
are still publicly owned, but the government has the Southern Cone, have proceeded much more
liberalized the credit ceilings and interest rates of cautiously. Several countries, particularly Brazil
public banks and shifted control to the banks' and Mexico, were more successful in building balmanagements.
Certain categories of deposit and anced and diversified institutional structures. But
loan rates, however, remain controlled. Korea also financial reform there and elsewhere in Latin
changed its financial policy in the 1980s, moving America was hindered by the failure to reduce inaway
fronm heavy regulation to a more market- flation.
oriented approach. These reforms have led to In Sub-Saharan Africa financial reforms are in
rapid growth in the financial sector (see Box 9.2). place or under way in several countries, including
Financial reforms in Greece, Morocco, Portugal, Cote d'lvoire, Ghana, Guinea, Madagascar, Moand
Tunisia have included a substantial reduction zambique, Nigeria, and Tanzania. The objectives
in directed credit programs, an extensive- are to restructure institutions, improve regulatory
although far from complete-liberalization of inter- procedures, and prepare the way for a greater reliest
rates, and efforts to develop money and capital ance on markets. The centrally planned economies
markets. have also undertaken some financial reforms that
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