Has Korea Voted Out Reform?

President Kim may be badly weakened for the rest of his term

It's a bitter blow for one of Asia's great reformers. South Korean President Kim Dae Jung had told voters he needed a strong mandate to forge ahead with his tough-love economic reforms. But the appeal fell largely on deaf ears. In parliamentary elections on Apr. 13, Koreans voted along regional lines--as usual--strengthening the opposition and leaving Kim's party in second place.

The electoral setback could mean policy paralysis at the highest level of government, just as a fresh surge of reform is required. Korea's recovery has been remarkable, but it has hidden dangerous cracks. Even as Korea's publicly traded manufacturers posted a record $13 billion in combined profits, total interest-bearing debt last year stood at $554 billion, 1.4 times gross domestic product and little changed from 1998. The financial system remains buried under an estimated $100 billion in bad loans. And the chaebol continue to ignore shareholder rights, even though their dynastic founders own 7% or less of their fiefdoms. "Lots of messy problems remain unresolved," says Park Kyung Suh, who teaches finance at Korea University. "But it looks like we have lost momentum for reforms."

The question is whether Kim can reshape the system before another financial crisis erupts. That prospect may not be as farfetched as it sounds. Reforms have advanced enough now that Korean capital markets are almost entirely opened up to foreign investors. A major outside shock such as a lasting plunge on Wall Street or a sharp interest-rate hike in the U.S. could wreak havoc on the Korean economy, which is still not strong enough--nor reformed enough--to glide through such turbulence. If investors yank their money, Korea's stock market could crash, financial institutions heavily invested in securities could be forced to curb lending, and companies could go belly-up.

Koreans got a preview of what could happen in mid-April, when Kim's electoral defeat and a Wall Street dive drove the Seoul bourse down 15.4% in two days of trading. "We should be racing against time," says a government economist. "The global economy won't wait for Korea's turnaround before it turns sour."

Kim's restructuring crusade already has run into fierce opposition from the chaebol, investors, unionists, and the conservatives in his administration. Now, oppositionists are trying to roll back reforms. They want to quash a requirement that the chaebol keep debt below twice their equity, and halt the sale of Daewoo Motor Co. and other major assets to foreigners. They also have pledged to guarantee individual bank deposits of up to $36,000, more than double the government's limit. That's a prop to the country's sick banks--and a direct challenge to the President, who aims to wean unprofitable lenders off state life support.

Kim now has the unenviable job of pressing on with the toughest part of financial reform: cutting off loans to companies that are failing even to service debt. "Change in the banking system is not only necessary to strengthen competitiveness but also to reform the chaebol," says Seoul National University economist Chung Un Chan. By tightening loan screening and carefully monitoring the projects they finance, banks will ensure the chaebol focus on profitable core businesses.

That's the theory. The problem is, the cleanup is only half done. Over the past two years, the Kim government has spent $58 billion, or 14.2% of gross domestic product, to clean up the financial system. To finish the job, his administration will need to spend billions more of taxpayer money.

Part of Kim's dilemma is that the reform process keeps turning up more bad news, which rattles local investors and rocks stocks. Consider the government-backed breakup of Daewoo, formerly the No. 2 chaebol. While its dismemberment telegraphed that the chaebol could no longer expect bailouts, it also revealed the depth of its financial trouble. An independent audit found that Daewoo's total debt was not $70 billion but $80 billion, while its assets amounted to $54 billion instead of the $83 billion the company claimed.

Such revelations make it harder for Kim to tackle the banking mess. Investors now dump stock in lenders exposed to companies like Daewoo, and the panic selling weakens the bank sector further. A year ago, the stock price of Hanvit Bank, Korea's No. 2 lender, was riding high at $13, in large part because the Korea Asset Management Corp., set up by the Kim administration, had bought $3.4 billion of its bad debt. Today, the stock is trading around $1.70, and Hanvit has set aside $2 billion, or 60% of its exposure to Daewoo. Now it may need another rescue.

HOW TOUGH? As the post-election dust settles, suggests Finance and Economy Minister Lee Hun Jai, the government will not announce any major new reforms and will try to keep its vow not to spend more than the $58 billion earmarked to restructure the finance sector. But investors will be watching the Kim administration closely for signs that it is losing its reform zeal.

An important measure of its resolve will be the severity of the penalty imposed on Daewoo executives and auditors for the creative accounting they employed to hide the state of the group's books. Another test arrives July 1, when troubled investment trust companies are supposed to let the market determine the price of their bond holdings. That's the honest way to account for securities. But it will expose Korea's individual investors to the vagaries of the market. These are the tough measures the economy still needs but which may now be political suicide to sell. Koreans today are weary of reform--and perhaps of their great reformer, too.

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