Impacts, Transmission and Recovery
KDI/EWC series on Economic Policy
Edited by Maurice Obstfeld, Dongchul Cho and Andrew Mason
Chapter 5: How Did Korean Financial Markets Get Infected by the Global Financial Crisis?
Hangyong Lee and Min-Kyu Song INTRODUCTION The Korean economy was hit hard by the global financial crisis. High short-term external debt resulted from excessive short-term borrowing by banks before the crisis, and the subsequent large-scale capital outflows raised concerns about another currency crisis in Korea. This chapter attempts to explain why external debt was increasing rapidly, before the September 2008 bankruptcy of Lehman Brothers, and how financial instability in advanced countries generated an immediate and powerful spillover to the Korean economy. Korea appeared to be enjoying steady macroeconomic performance up to the time that the global financial markets were shaken by the bankruptcy announcement. Even when the subprime mortgage problems came to surface in mid-2007, the initial impact on the Korean economy was limited in scale and severity. Despite the underlying strength of the fundamentals in the Korean economy, however, vulnerability was arising from increased openness in international trade and finance. Greater openness can contribute to robust economic activities in normal times, but at the same time it can widen channels through which the shocks originating in advanced countries could be transmitted to the Korean economy. Following the bankruptcy, financially vulnerable Korea experienced large capital outflows and serious difficulties in refinancing liabilities denominated in foreign currency. Then exports and industrial production plummeted, as a result of contracting global demand in late 2008, leading to a pronounced deceleration of economic growth. In the literature on contagion, countries can be linked through two different channels of transmission: the international trade channel and...
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