After two major wars, the country even with a food shortage experienced lack of capital. There was no source for savings and investment to finance economic growth domestically, so it depended heavily on foreign capital which inflow in a form of mostly aid and loan in the early stage of economic growth. The proportion of foreign capital to total capital formation in 1965 was approximately 40 percent. In addition to inflow of foreign capital, the government faced allocation of capital with using its financial system. Before the military government in 1961, the loan decisions of commercial banks were heavily influenced by political interference (Haggard, 26). Well, in fact the loan decisions in Korea mostly were affected by political interference rather than bank themselves until recent time, but during the 1948 ~ 1961 period, the rent generated by low interest rate was used for its political activities rather than economic growth. Government's Export Promotion Policies In the economic development, the government's creation of economic rent for certain segments of business takes critical role.
It can be either a source of political and bureaucratic corruption, but if wisely used, it can be a useful or powerful policy instrument in supporting business operation and government policies. Furthermore, it can increase capital formation in the country if it effects a redistribution of income from consumption to investment activities (Haggard, 23). Since the mid 1960s, the military government used regulated finance as one of tool to create rent and achieve exports expansion. What it did were nationalizing commercial banks and amending the Bank of Korea so that it can control financial systems directly. In general, the Bank of Korea, in its role as the country's central bank, determines the allocation of loans, interest rate level and the supply of money but the decision making in these area is controlled by the Minister of Finance. In other words, it was government's responsibility generating monetary and fiscal policy, not by the central bank. Since foreign aid started to decline later 1960s, the government reformed interest rate.
It raised the interest rate on (one-year) time deposits from 15% per year to 30% per year and general loan rate from 16% to 26%. The reform successfully attracted private saving. In the first three months after reform, saving deposits increased by 50%. More importantly, this meant more rent, in other words, more capital to be distributed under government influence. In addition, the financial reform contributed to a massive inflow of foreign loans due to the existence of gap between domestic and international interest rate and since the Korea Development Bank guaranteed to pay back to foreign lender, the inflow of the loans were accelerated. Also this gap of interest rate was used to promote export expansion which was the most economic priority. For example, while domestic interest rate was so high comparing with international rates, the exporters, mostly big business in heavy industry, were able to get loan at little interest rate.
They were not only able to get low interest rates, but variety of supports that the government could do such as tax break and easy approval of the loans for exporters. For example, profits earned on exports have been exempt from corporate or individual income tax and the short-term export credit system gave borrowers holding export letters of credit (L/C) "automatic approval". As a result, an increase in domestic savings and huge inflow of foreign borrowings had positive effect on economic growth in Korea due to an increase in capital accumulation.
Controlling exchange rate is another good example to describe the effect of government's role on Korean economic development. After switching its economic policy from import substitution to export expansion in the mid-1960s, the Korean government officially moved from a fixed parity to a unitary floating exchange rate system. Although the exchange rate system has been «floating», its actual (real) rate was managed by government's market control and Korean currency «won» was undervalued mostly against the U.S. dollar so that the price of exports remain cheap. Followings are the plans that the Korean government set over time period as a guide for economic growth. They are quite helpful to understand how major government's policies on financial sector have been varied with given the world economic situations like oil crisis and its own economic recession. The First Five Year plan (1962′ 1966) The first plan was prepared in a hurry by the military government that took power in 1961.
The major contents of fiscal and financial policies as stated in the plan document were largely about the tax, budget, and monetary system, financial market and foreign exchange system. During this period, its main purpose was, however, to expand exports as much as possible by providing export firm with cheap loans, tax benefits, export compensation schemes, and various administrative support. Economic growth in this period was result by an increase in export and output and as well as price level (since output and price level are positively correlated), so there was inflationary pressure at the end of the first plan- actually the inflation rate exceeded 23 percent in 1964. The Second Five-Year Plan (1967′1971) During this period, the major reforms include a financial reform assuring positive interest rate in 1965, and exchange rate reform normalizing highly overvalued exchange rate, and trade reform allowing wide imports of parts and machinery used for the production of export goods.
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