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agreed to provide Korea with U.S.$55 billion or more in a bailout package. Exhibit 3
shows the chronology of events surrounding the crisis; the rapid change in the value of

Korea Stock Exchange 1998
Korean won during 1997 and 1998 is shown in Exhibit 4.

The Search for Causes
Many observers, both inside and outside Korea, were stunned by the rapid change of in-
vestor sentiment. The darling of foreign investors and economists until then, Korea
found itself in the middle of an economic crisis that threatened to wipe out the fruits of
hard work of a whole generation. As a sense of gloom enveloped the country, a heated
debate focused on the search for the root causes of the crisis.
The nexus of the banking system and the chaebols, once viewed as the means to rapid
economic growth, came under increased attack. In¬‚uential policy makers, including
those at the IMF, believed that the chaebols, with their close connections to politicians
and government of¬cials, could get loans without much resistance from banks. As a re-
sult, the vaunted “relationship ¬nancing” model, meant to facilitate long-term invest-
ments, was now viewed more as facilitating “crony capitalism.” A consensus began to
emerge that, with easy access to ¬nancing, a lack of supervision by banks, and the gov-
ernment™s emphasis on job creation, chaebols focused excessively on growth and expan-
sion and ignored pro¬tability.
On December 19, 1997, in the middle of the serious economic crisis, Kim Dae-Jung
won the election as president of South Korea. Soon after entering of¬ce, President Kim
noted that big business groups, together with government of¬cials in power in the past,
must take responsibility for having brought the economy to near collapse. He pro-
claimed that it was the collusion between the government and business, the govern-
ment™s control of ¬nance, and widespread corruption that had battered the economy.
Kim said, “Unless chaebols implement reform, they would face the recall of existing
debts or the suspension of fresh credit. Only pro¬table enterprises and exporting com-
panies will be regarded as ˜patriotic™ ¬rms eligible for government supports.” 8

The IMF Program
As a condition for IMF bailout loans, receiving countries must adhere to the economic
programs prescribed by the IMF. Michel Camdessus, IMF managing director, stated:
“The program comprises strengthened ¬scal and monetary policies, far-reaching ¬nan-
cial reforms and further liberalization of trade and capital ¬‚ows, as well as improvement
8. Lee Chang-sup, “Kim rules out new currency crisis, Korea Times , September 28, 1998.
A Framework for Business Analysis and Valuation Using Financial Statements

1-17 Part 1 Framework

in the structure and governance of Korean corporations.” The IMF™s program for Korea
was heavily in¬‚uenced by the conclusion that it was time for Korea to signi¬cantly
restructure its ¬nancial and industrial sectors (see Exhibit 5 for details of the IMF-sup-
ported program of economic reform).
Some Koreans were positive about the IMF program because they felt that it could
serve as an opportunity to sharpen Korea™s international competitiveness, even though it
Korea Stock Exchange 1998

was to be carried out by the force of outsiders. There were, however, others who ex-
pressed concern that the rapid changes proposed under the program were not only unre-
alistic but could lead to signi¬cant layoffs and social instability. In fact, the common
reference to the economic crisis as the “IMF crisis” re¬‚ected the ambivalence in the
Korean reaction to both the causes and the remedies being debated.

To implement the IMF program and to restore international con¬dence in Korea, the
newly elected government of President Kim Dae-Jung began to pursue aggressively ¬-
nancial sector reforms and a total restructuring of chaebols. To this end, the Financial
Supervisory Commission (FSC) was established on April 1, 1998, under the Prime Min-
ister™s jurisdiction to supervise all ¬nancial institutions including banks, securities ¬rms,
and insurance companies. The restructuring process of the ¬nancial industry and the cor-
porate sector was administrated by the FSC. The FSC pursued a strategy of sequential re-
structuring, beginning with banks and accelerating corporate sector restructuring
through bank reform.

Bank Restructuring
The FSC requested twelve banks that fell short of the 8 percent capital adequacy ratio
(as of December 1997) set by the Bank for International Settlement (BIS) to submit re-
habilitation plans. Bank appraisal committees and accounting ¬rms assessed the size of
nonperforming loans through asset due diligence reviews and made full provision and
write-offs based on the actual size of nonperforming loans. Based on this review, the FSC
conditionally approved the bailout of seven banks and ordered the closure of ¬ve nonvi-
able banks. Conditionally approved banks were asked to submit implementation plans
which included changes in management, cost reductions, and recapitalization plans such
as mergers, joint ventures, or rights issues.
The ¬ve banks which were classi¬ed as nonviable were to be acquired by healthy
banks. To protect acquiring banks from spilled-over problem loans, several measures
were taken: only good assets would be sold with a six-month put option; government

9. This section is based on reports published by the Ministry of Finance and Economy (MOFE) and the Financial Super-
visory Commission (FSC) in Korea.
18 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Valuation Using Financial Statements

would inject fresh capital to enhance the acquiring bank™s capital adequacy to pre-acqui-
sition level; the acquiring bank™s bad assets would be purchased by Korea Asset Man-
agement Corporation, funded by public resources; and deposit guarantees would be
honored until the completion of all restructuring in order to prevent any bank runs.
One example of bank restructuring was a merger between Commercial Bank of Korea
and the Hanil Bank. On July 31, 1998, following the guidelines of the FSC, the two banks

Korea Stock Exchange 1998
announced a one-to-one merger. The newly merged bank proposed that in order for it to
succeed, the following actions would be taken: (1) an accountable management system
through drastic management improvement; (2) early resolution of nonperforming loans
through injection from public resources; and (3) capital injection from international
A key issue in the normalization of the Korean ¬nancial sector was to develop a plan
to clear nonperforming loans. At the end of March 1998, the nonperforming loans of
¬nancial institutions were estimated to be about 120 trillion won, which is about 23.3
percent of Korean ¬nancial institutions™ entire credit portfolio. The Korean government
estimated that the total market value of the nonperforming loans would be equal to 50
percent of their book value. The realized losses borne by ¬nancial institutions were
therefore estimated to be approximately 60 trillion won.
To ¬nance these losses, the Korean government planned to raise 50 trillion won
through government bonds. From this amount, 41 trillion won would be used to pur-
chase nonperforming loans and to recapitalize the affected ¬nancial institutions; the re-
maining nine trillion won would be reserved for the potential new demand for increased
deposit protection. The government expected ¬nancial institutions to issue new equity
worth twenty trillion won, which accounted for as much as one-third of total current cap-
italization in the Korean stock market.

Corporate Restructuring
In the short term, the Korean government™s focus with respect to corporate restructuring
was to shut down nonviable enterprises, and to improve the ¬nancial condition of the
rest. In the long term, the objective was to improve the management and governance of
the corporate sector in general, and of the chaebols in particular. To achieve these objec-
tives, the FSC delineated ¬ve principles of corporate restructuring: (1) improving the ¬-
nancial structure, (2) eliminating the practice of mutual guarantees of loans among
af¬liated ¬rms, (3) focusing on “core” business sectors, (4) increasing transparency, and
(5) improving corporate governance (e.g., increasing major shareholders™ and manage-
ment™s accountability).
In order to direct the restructuring process, the FSC classi¬ed all Korean companies
into three categories. Companies classi¬ed as “viable” would receive full support from

10. Joint press conference upon announcement of merger between the Commercial Bank of Korea and the Hanil
A Framework for Business Analysis and Valuation Using Financial Statements

1-19 Part 1 Framework

¬nancial institutions; those that were classi¬ed as “subject to exit” would be sold off or
shut down on a timely basis; and those that were classi¬ed as “subject to restructuring”
would bene¬t from proactive support toward restructuring from ¬nancial institutions. In
June 1998, 55 corporations, which represented 17 percent of the total number of corpo-
rations subject to the assessment, were classi¬ed as nonviable and ordered to exit. Of
these 55 corporations, twenty were af¬liated companies of the top ¬ve chaebols (Hyun-
Korea Stock Exchange 1998

dai, Samsung, LG, Daewoo, and SK), and 32 were af¬liates of the top 6 to 64 business
One of the senior of¬cials at FSC stated: “To reduce excessive reliance on debt ¬nanc-
ing, the government set a target for reducing Korean companies™ debt to equity (D/E)
ratio from the current level of approximately 500 percent to a level of 200 percent by the
end of 1999. To meet this requirement, Korean companies had to raise more equity or
sell off some of their assets.”
Korean chaebols were directed by the FSC to formulate restructuring plans with a
view to identifying core businesses on which they would focus, and to close down or di-
vest the rest. To improve transparency and governance of individual companies in a
chaebol, new guidelines curtailed the role of the central corporate of¬ce, and prohibited
cross-guarantees. The top ¬ve chaebols were cajoled into the so-called “Big Deal”
swaps of business units in order to boost national competitiveness by cutting out some
domestic competition. To expedite the pace of corporate restructuring, government sub-
mitted the legislative articles, such as allowing tax bene¬ts to restructuring, simplifying
the mergers and acquisitions process, and permitting corporate spin-offs/carve-outs, to
the coming session of the National Assembly.

Attracting Foreign Capital
Recognizing the importance of foreign capital for the successful restructuring of Korean
banks and chaebols, President Kim Dae-Jung proclaimed his intention to make South
Korea a haven for foreign investors. Foreign investors were essential in several ways.
First, since all major Korean companies were looking to sell assets and raise new capital,
the only viable buyers were foreigner investors. Second, foreign investors brought with
them world-class management and governance practices to Korea.
To attract foreign capital, the government proposed several new policies. Under the
new policy, foreign ¬rms were allowed to freely establish mutual funds in Korea. At the
same time, restrictions on foreign investors were also reduced. Earlier, foreign investors
needed the approval of the board of directors of a company to buy more than ten percent
of its outstanding shares. On May 25, 1998, under the new rules, the ten percent limit
was completely abolished. The government also granted special privileges to domestic
companies that attracted foreign investment or sold their assets to foreigners.
While these moves were somewhat effective in increasing foreign investors™ interest
in Korea, several hurdles remained. Deals for foreign direct investment could not be con-
summated because of widespread disagreement in valuation estimates of Korean sellers
20 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Valuation Using Financial Statements

and foreign buyers. These valuation dif¬culties were exacerbated by the poor quality of
accounting information. Further, foreign buyers were uncertain about the ease with
which they could lay off employees. Despite the recent agreement between government,
industry, and labor unions to cooperate in the restructuring process, the possibility of
widespread lay-offs, especially by foreign owners, could be received with hostility.
The popular sentiment towards foreign direct investment was also ambiguous. On the

Korea Stock Exchange 1998
one hand, the Korean government undertook a process of educating Koreans that attract-
ing international investors was critical to economic rebuilding. On the other hand, there
was a popular feeling against foreign investment, partly due to the 40-year Japanese rule
of the country that ended in 1945. As a result, while many American franchises such as
McDonald™s and KFC have prospered in Korea, symbolic gestures against foreign invest-
ment abounded. When Microsoft attempted to buy a Korean word processing software
company in ¬nancial distress, there was a fund-raising campaign to save the company
and keep it in Korean hands. Even though the amount of foreign investment involved in
this deal was only about U.S.$20 million, it was symbolic.
Foreign investors were also wary of the risks involved in investing in Korean compa-
nies through the stock market. Even in advanced capital markets, investing in stocks in-
volves taking additional risks relative to investment in bonds or bank deposits. Unlike debt
holders, shareholders are not promised a ¬xed payoff. Finally, when insiders have a con-
trolling stake, they can take actions that are potentially harmful to the minority sharehold-
ers. In advanced markets, these potential risks faced by public shareholders are mitigated
through a variety of mechanisms such as credible ¬nancial reporting, minority share-
holder protection laws, the threat of hostile takeovers, scrutiny by an aggressive analyst
community, and the supervision of management by an independent board of directors.
In Korea as of early 1998, many of these institutional mechanisms that protect share-
holders and reduce their risks were either absent, underdeveloped, or poorly enforced.
Relative to international standards, accounting rules and disclosure regulations were lax;
there was a widespread belief that external auditors were either unwilling or unable to
exercise independence; it was rare for shareholders to sue corporate managers or audi-
tors successfully; boards were viewed as being too close to corporate managers; there
was no effective threat of a hostile takeover or a proxy ¬ght to replace a company™s man-
agement; and the ¬nancial analysts themselves often worked for brokerage houses
owned by large chaebols. The net result of these institutional voids was a perception
among investors, both domestic and foreign, that investing in Korean stocks was very


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