PSPD l People's Solidarity for Participatory Democracy
Korea : Economic Consequences of Corruption in Korea
- 2001.01.31 (00:00:00)
Korea : Economic Consequences of Corruption in Korea
Taekwon Kim, Graduate School of International Studies, Yonsei University
I. Corruption: Definitions and Its Economic Consequences
1. 1 Definitions of Corruption
Why corruption is so problematic? The word corruption itself carries the connotation of something ethically bad or wrong. Is the corruption simply an ethical issue? We can approach to the corruption from two different perspectives: normative and pragmatic.
Normative approaches help us define the corruption from moral and ethical perspectives. They start with important presumption that corruption is ethically and morally wrong. Therefore, it is unethical if it is corrupted. Normative approaches tend to emphasize moral and ethical aspects of corruption, which indispensably need the value judgment of human activities. We can say that any human activity against a certain value system is corrupt from normative perspective. We can also say that corruption, therefore, is ubiquitous as long as human beings are prone to temptations.
However, we believe that corruption is more than an ethical issue. Being a good citizen is not just for moral and ethical satisfaction of your own or our value judgment. Corruption actually severely damages not only other peoples but sometimes those who committed corruption themselves: corruption is not only a sin but a crime that should be prevented for better society.
It is, in fact, a very pragmatic question of how to prevent corruption because corruptions are very costly regardless of ethical or moral implications. In this paper, our goal is to find out how devastating the economic consequences of corruption are from a pragmatic perspective.
There are various definitions about corruptions according to previous research on corruptions*. Corruptions occur when people abuse the power to make decisions. In public sector, corruption occurs when public office is abused for private gains by the definition of World Bank and IMF.
Whenever a public office is abused, a public function or objective is set aside and compromised, which results in wastes of public funds or misallocation of resources. In private sector, corruption can also occur when decision making power is abused for private gains in case of making procurement decisions, lending decisions, embezzlement of corporate funds, abusing corporate funds, even in human resource management decisions. All these activities of abusing powers negatively contribute to corporations profits or competitiveness. Furthermore, it will hurt the reputation and credibility of corporations to put the unnecessary stress on the financial costs of the corporations. Consequently, corruption in private corporations do to harm shareholders, particularly minority shareholders, to subcontracting firms, to banks and financial institutions that provided credits to the corporations, ultimately to publics by wasting tax money.
1. 2 Economic Consequences of Corruptions
It is impossible to precisely measure how much the corruption causes economic damages due to its very intrinsic nature of secrecy, illegality and variations across different economic activities.
However, previous research strongly supports that corruptions ultimately do harm to competitiveness of firms, industries, and economy by inefficient allocations of social resources and discrediting government policies with unwanted results of lowering business and sovereign credit ratings, which contributes to the unnecessary increase of costs in doing business in the region*. Over the long run, corruptions undermine a sound economic development caused by inefficient allocation of resources, hampering domestic and foreign direct investment, ultimately economic growth*.
This paper will examine the economic consequences of corruptions in Korea by looking at how much the corruption practices in Korea did cost in recent increase in public debts and rescuing and cleaning up banks and financial institutions where the causes of corruptions are materialized as non-performing loans and bad assets.
II. The Corruption Activities in Korea
It is generally accepted that there is a positive relationship between corruption and underground economy. (Examples, Daeyoung Oh and Sangmin Shim, 1995) Foremost, the slush fund of companies can be often regarded as a main source of corrupt practices, such as illicit lobbying or unlawful hospitality. Therefore, it is imperative to estimate the total volume of the slush fund and underground economy for better understanding of the change of corruption activities in total.
2.1 The size of underground economy in Korea
The definition of underground economy shows considerable difference between countries and scholars and more than one terminologies are being used to describe the activity. Moreover, no universal methodology exists for its estimation. This indicates that scope of related economic activities can vary depending on how we see and define the underground economy.
Table 1 and 2 show prior research results of the size of underground economy in Korea and overseas.
〈Table 1〉Estimation of underground economy in Korea
The Korean government has not published an official record of the size of underground economy. Although there are some data offered by private research centers, they show considerable differences from 10% to 75% of GNP.
〈Table 2〉Estimation of underground economy in Korea applying Tanzi methodology
According to a KIPF (Korea Institute of Public Finance) analysis applying Tanzis methodology, the size of the underground economy in terms of GNP in Korea has decreased to 9.0% in 1992 from 16.6% in 1972, and reached 8.8% in 1994 after the account holder verification act had come into force. However, its absolute volume has continuously increased from 6.96 billion won in 1982 to 26 trillion in 1992 and 652billion won in 1994.
2.2 The size of the Slush Funds and Entertainment Expenses of Korea firms
It is really impossible to have an accurate measure of the slush fund in private companies. Therefore, the data, which is used here, is a result of the report of the Committee for the Prevention of Corruption.
The committee claims that 5~7% of the total underground economy is the slush fund, which accounts for as big as 0.5~5.25% of GNP. The fact that this volume is no less than the Korean governments budget allocated for education indicates the level of corruption. The committee also analyzed the size of slush fund compared to total sales volume in five different industries as shown on table 3.
〈Table 3〉The size of the slush fund in Korea (By industry)
According to the Current Situation and Countermeasures of Reception Expenses of Korean Firms released in July 1997, the greasing expenses, either official or unofficial and including secret fund, can be regarded as a bribe. Hence, we can judge the level of Korean firms corruption activities by carefully examining the volume of their entertainment expenses.
Fist off, official entertainment expenses in all industries except Banking, Insurance, Agriculture/ Fishery, estimated by the Bank of Korea based on Year 1995 Financial Statements amount to 1,624 billion won. (Refer to )
Changes in Official Entertainment Expenses and show that average 1~3% of revenues are paid for corruptive expenses including slush funds and unofficial entertainment expenses in the form of bribery if some differences exist between firms. The percentage is high relative to the current profit rate of 3.6% of manufacturing industry and 1.14% of construction industry in 1995. The relatively low rate of 0.99% and 0.67% in 1996 can be explained by different accounting rules of treating entertainment expenses and slush funds.
2.3 The changes in corrupt practices in Korea
It is surprising to see how corruptive Korean politics was from the several past incidents such as slush fund formation of the two former presidents Chun and Noh, and other similar cases divulged during the recent presidential campaigns.
What is worse is that similar deteriorated events have occurred in Korea during the former president Kim Young-Sam administration, who has promised not to accept any kind of political fund after elected. Hence, we have to pay close attention to the fact that the corrupt practices in Korea have never decreased but rather increased in an absolute volume for the past two decades.
The reasons for the surge of corrupt practices can be derived not only from the growth in Korean economy but the corruption structure in Korean society. The transaction cost theory explains that the corrupt practices can lubricate economic transactions. This indicates the economic growth will lead to the increase of corrupt practices unless there is a concomitant change in political and economical structure. Accordingly, the slush fund as transaction cost gives a partial answer why corrupt practices have grown as a result of its economic growth in Korea where still high government regulations exists
More fundamental question is why the corrupt practices have steadily increased despite the 10-year efforts of political democratization, liberalization of civil affairs and deregulation. A compelling explanation on this can be found in the structure of corruption, which has changed with the democratization of Korean society. The structure has evolved into more a competitive structure of corruption with larger number of bribers and bribees including low-level officials, from a prior reciprocal corruption structure, where only a small number of bribers and a small number of upper-level decision makers were involved. As mentioned earlier, the transition in the corruption structure best explains the increase of corrupt practices.
3. Economic Consequences of Corruption in Korea
How large can be the economic costs of corruption? The various social and cultural aspects and the secrecy of corruption make a reasonable measurement of total cost incurred by it almost impossible. As we discussed before, corruption contributes to the loss of economic competitiveness, which results in huge clean-up costs of firms, banks, and corporations. Given the characteristics of Korean financial system controlled by government, lending practices of banks and non-banking financial institutions, the economic consequences of corruptions in Korea are well represented by the magnitude of costs incurred by write-up of bad loans of banks, rescuing bad banks and financial institutions, and investors loss of confidence on markets.
Therefore, instead of investigating all various kinds of corruption to generate their total economic costs, the settlement cost of the financial crisis and the amount of bad debts and a subsequent macro economic change will be presented to show how seriously the corruption can hurt economy. We will add cases on Hanbo and Kia to illuminate the possible corruption linkage in Korea before IMF crisis. We will also discuss two recent events, illegal lending by Hanvit Bank to Arc World and Hankuk Digital Line scandal.
3.1 Bad Corporate Performance Supported by Financial Institutions
Historically, Korean conglomerates have severely diversified its businesses with no sound economic fundamentals, by heavily depending on short-term debts. A more comprehensive examination, tells us how a structural corruption characterized by the cozy relations between politics and economics has enabled Korean chaebols to maintain rent-seeking behaviors to exploit preferential loans, regulatory protections, government contracts, etc. They have asked government to subsidize their costs of doing business by preferential loans from banks and provide markets by government contracts and other protective measures. Corporations prepared slush funds to finance political campaigns and to bribe politicians, government officials, and bankers. They sometimes even used the money borrowed from banks to support such corrupted activities exemplified in Hanbo case. With strong government interventions, most of business activities directly or indirectly got involved in government regulations that consequently encourage corruptions.
The inevitable consequence of such abuse of power is a mountain of non-performing loans of banks followed by bankruptcies of many of Koreas top thirty conglomerate groups, starting from Hanbo in January 1997, Sammi, Jinro, Kia, and Halla Group. The serial of tragedies can be attributed to dropping productivity caused by a fall in price of their primary products, such as semiconductors and skyrocketing cost of capital.
Table 5 shows the amount of bad debts that Korean banks were forced to bear before IMF crisis.
Monthly rate of dishonored bills
As shown on the tables 6 and 7, insolvent corporations with a deteriorated financial structure by low profitability and excessive financial costs have prolonged their businesses by only depending upon short-term loans and preferential loans from the aid of government officials and banks.
After IMF crisis, government has put much effort on corporate restructuring and financial sector restructuring for economic reform. It is estimated that the total amount of 64 billion U. S. dollars in public fund has been injected for cleaning bad loans and rescuing financial institutions.
However, this public fund has been used for just correcting balance sheets of banks and financial institutions without helping corporate restructuring. In the meantime, government has pushed the structural reform of big conglomerates. As seen in the following table, the debt-equity ratio of the top thirty conglomerates has been improved.
However, there has been no significant improvement of competitiveness of firms.
For example, Bank of Korea found out that the financial costs to firms actually has risen to 6.9% of total revenue in 1999 from 5.8% of the total revenue during 1990 to 1997. Joonang Daily, July 13, 2000.
Another bankruptcy of big corporation can cause another serious damage to Korean economy. For example, the bankruptcy of Daewoo group posed another threat to restructuring efforts. The following tables show how serious Daewoo case is.
Total Loans by Daewoo Group from 1997-
Performance of Daewoo Group 1997
Disguised Loss of Daewoo Group
Daewoo group also has been known for its close relationship with political circles. It has been associated with government preferential loans in the past. The Former chairman Woo-Chung Kim also had been charged for illegal provision of election campaign funds. As you see in
Table 11, Daewoo also disguised the actual loss, which misled investors and creditors.
3.2 Hanbo and Kia Cases
The Hanbo case is a typical example of corruption, where three players, such as bureaucrats (including upper-level officials), banks and private companies are involved. From the beginning, the entry of Hanbo into the steel industry was approved by Ministry of International Trade and Industry and financed by banks. The decision-making process of whether to approve its steel business was based not on sufficient economic analysis but on political power and links that Hanbo had, which forced the banks to refinance their loans to Hanbo. The banks, however, rejected to extend the loan in the wake of the fifteenth presidential election and let Hanbo go bankrupt.
The consequence of the illicit links between Hanbo, bureaucrats and banks was a considerable loss to Korean economy as shown on table 8.
The bankruptcy of Kia Group was a consequence of excessive government control and regulation coupled with careless management and over-diversification of Kia. There was no explicit evidence of direct government involvement but excessive government interventions to bail out Kia by manipulating financial institutions were witnessed when Kia announced its insolvency.
Kia Group needed to be treated as a special case because its treatment would have a close relationship with Samsungs entry into automobile industry. At the brink of bankruptcy with loaded short-term debts and mounting losses, Kia was forced to finance anti-takeover measures, such as stock price support and stock purchase, in the face of the rumors that Samsung had a takeover intent of Kia. Kia tried all attempts to defend its management by even borrowing a short-term loan from informal private curb market, which led to more deteriorated financial structure and, in the end, the creditors announced to initiate a workout plan in July 15.
Despite the distorted financial structure and considerable operating losses, a banking sector did not take it as a serious matter because there has been a prevailing perception of the strong government will not to let such a big company like Kia go bankrupt. Moreover, the high level of corruption of insiders during the process of simultaneous implementations of many large-scale projects can be considered as a critical cause of the demise of Kia Group.
The economic impact of Kias bankruptcy was amplified by its chairman, Sunhong Kim, who sought a political resolution of the case and the government agencies, which fought for their departmental interests. The conflicts between the chairman and the department of finance and economy extended the resolution process to aggravate the difficulties of banks.
Consequently, the prolonged resolution process of Kia Group brought a significant economic damages into a financial market in Korea. The calculation of economic losses only based on available data amounts to 70 trillion won and it can be even more when the losses to related companies were added up to the calculation.
The economic losses caused by the protraction of Kias bankruptcy
The effect of Kia on the foreign exchange market, which had been recovering from previous Hanbos bankruptcy was even more devastating. Table 11 shows that at the time of Kias bankruptcy, the economic indicators, such as exchange rate, stock price and interest rate had been all back up to the pre-Hnbo level.
Comparisons of the situation in the Foreign Exchange Market
The protraction of decision of Kias bankruptcy brought the worst scenario of the bankruptcy chain, increasing interest rate and difficulty in foreign financing due to the drop in international ratings. For example, the number of bankruptcy among listed firms in Korea soared to 8.9% (68 among the total number of 760 listed firm) in 1997 from 0.8%(6 among the total number of 721 listed firm) in 1996. The consequence was a resort to IMF in avoidance of moratorium. As a result, the interplay between Kis top management, bureaucrats and banks linked with bribes and consequent preferential policies to Kia for gratitude charged exorbitant losses to Korean economy.
3.3 Recent Scandals : 'Arc World' and 'Chung Hyun Joon Gate'
'Arc World' *
This case illuminates how an alleged political connection can be abused for illegal and corrupt lending activities. A branch office of Hanvit Bank had provided 46.6 billion won as lending to Arc World and its related companies in illegal manners. This illegal lending has started from early 1998 just after President Kim assumed the presidency.
Investigation by prosecutors office of this case evolved into arresting a former aid in Blue House, whose elder brother was also arrested for illegal borrowing from the Bank. There has also been an allegation that Mr. Jiwon Park, former minister of Culture and Tourism, was also deeply involved in this scheme allegedly putting pressure on related financial institutions to lend more money to Arc World. There is an unavoidable loss to Hanvit Bank due to this illegal lending since no full recovery of the original amount of money is possible now.
This case also reveals that bank officers were involved in getting their personal gains to violate internal regulations and even violate laws. There are several people involved in forfeiting letters of credit to create an void order of exports. Hanvit Bank has been in trouble for its poor performance even after it was restructured by merging Hanil Bank and Commerical Bank to rename Hanvit Bank. During the restructuring, government injected public fund to save the bank.
However, existence of corruption inside of the bank will only deteriorate banks performance by wasting public fund and deposits, which will result in more public fund injection if the bank is to be saved.
Chung Hyun Joon Gate Scandal
We have to wait until the full picture of the scandal to be revealed by thorough investigation because this scandal is still under investigation. However, this scandal already shows enough how corruption can take place to best exploit loopholes and abuse the regulatory power. Mr. Hyun Joon Chung, risen and fallen star of venture business and once known as Masao Son of Korea, lies at the center of this scandal that also involves financiers from mutual savings and finances companies, and bureaucrats from Financial Supervisory Service (FSS). This scandal also created a political backfire between ruling party and opposition party because key members of the ruling party are allegedly involved in this scandal through Ki-joon Oh who runs Shinyang Factoring and fled away on October 26. Mr. Oh allegedly played a significant role in recruiting senior politicians for Chungs funds.
Mr. Chung with Ms. Kyung-Ja Lee came up with a scheme to abuse two mutual savings and finance companies to finance Mr. Chungs troubled plan to sustain his empire of internet related business. Along the high wave of KOSDAQ, Mr. Chung could easily secure a lot of investment funds to merge and acquire internet business firms. Mr. Chung has been more interested in camouflaging the companies rather than improving the business fundamentals of companies that he invested or merged. During the process, he established private investment funds to secure enough capital to ambitiously carry out his plan of a financial game. He also guaranteed a certain rate of return on the investment made into these private funds. However, KOSDAQ has fallen significantly as bubbles busted off. Accordingly, he faced the liquidity problem by significantly lowered stock values of portfolios and turning away of investors. In order to solve his problem, he resorted on illegal lending of about 67 billion wons from two mutual savings, Daeshin and Dongbang.
Investigation immediately reveals that there has been an illegal preferential treatment of these two mutual savings and finance companies by FSS Instead of ordering liquidation of these two ragged companies, FSS took a very lenient position to end up issuing an official warning against management of these two mutual savings and finance companies. Investigation reveals that there has been bribery involved in these lenient measures by FSS.
Furthermore, brokers also approached officers of FSC to be lenient on Yu-Il Semiconductors for its doing harm to company and shareholders by issuing Bonds with Subscription Warranties (BS) at an unreasonably favorable conditions to CEO and other related people. There also has been an inside trading of Hankook Digital Line (HDL) stock by informing Mr. Kwon from a security brokerage to sell HDL stocks just a day before the company declared its insolvency.
There are already significant costs related to this scandal. Many investors already suffered from a significant loss caused by the insolvency of Hankook Digital Line and the precipitated stock price drop of Pyung Chang Info. And Communication. Furthermore, it is impossible to salvage the illegal lending of 67 billion. Mr. Chung is allegedly bankrupt and there is no enough collaterals to recover the loan.
4. Concluding Remarks
The above two recent scandals can be just a tip of iceberg. They may show that corruption is still a serious problem with grave economic consequences despite of governments reform efforts. If the recent financial restructuring effort has been distorted by the above corruptive actions in the name of leniency or saving jobs, Korea may need more public fund to clean up the mess resulting in ragged financial institutions that requires more sacrifices of people either by loosing their investment or paying more tax.
Foreign experiences can be a good benchmark to understand the economic consequences of just fixing the past problems of financial sectors caused by structural corruptions. When financial sector is in serious trouble, there are generally two kinds of measures to cope with a financial crisis, that is, government bailout by public money injection as in the case of Korea and the liquidation of beleaguered institutions as preferred in the U.S. and other developed countries. Government bailout needs more public money to save beleaguered institutions.
According to the report of Gerald Caprio and Daniela Klingebiel of World Bank, among the surveyed countries, more than 12 NICs have paid approximately more than 10% of GDP for
their financial restructuing costs. Given individual country examples, a 1990 financial crisis charged Kuwait 50% of its GDP. For the U.S., 2% for the resolution cost of the Saving & Loan Scandal amounts to only 2% and for Scandinavia 6-8%. A recent case is the financial crisis in Mexico, which has paid more than 10% of its GDP since 1994.
From the foreign cases, it can be concluded that the current manner of Korean Government in coping with financial restructuring as a mixture of capital injection and liquidation method will have an adverse effect on real economy. A considerable amount of a management cost in terms of a significant portion of GDP can be estimated, generating a reasonable conclusion that the cost of corruption in Korea will be stunningly large.
How costly is corruption to a society? Corruption erodes the competitiveness of business by raising costs of doing business and inefficient allocation of precious resources. It is very pragmatic reason that we want to eliminate corruption from our society because it is too costly to bear all the costs incurred by corruptions. It hampers down not only economic welfare but also social spirits. When corruptions permeate into the every corner of society, people tend to have a very lenient attitude toward corruptions. When they are caught for corruption, they just feel that they are unlucky. Then, inefficiencies are taken for granted. Justice will not be served.
Instead of trying to strengthen the fundamentals, corruptions tend to induce people to have a playing gamble mindset. Being short-sighted for big wind-fall gain like playing a gamble, people tend to be myopic neglecting long-term investment for individuals and organizations. Without long-term oriented investment, no competitive fundamentals is expected for individuals and organizations.
If you consider the possible implications of corruptions to future competitiveness in addition to cleaning up costs of the past corruptions, the economic consequences of corruptions cannot be overstated.
Corruption cannot be prevented by appealing to moral and ethical aspects only. It is not only legal framework but also institutions under which people carry out daily economic activities that affect the corruption activities. It is an institutional framework, in particular, an incentive system that hinders people from engaging in corruptions. Institutions should be restructured to emphasize transparencies and accountabilities that reduce hidden actions and moral hazards. Furthermore, the concept of fairness must be properly applied in order to establish a reasonable punitive systems. The incentives for corruption should be mimimized. Furthermore, the will of anti-corruption is crucial to an effective implementation of anti-corruption measures. The will of government, business, and people altogether must come along to crack down corruption activities in a society.
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