ICRR 10418 Report Number : ICRR10418 ICR Review Operations Evaluation Department 1. Project Data : OEDID : OEDID: L4302 Project ID : P056235 Project Name : Structural Adjustment Loan Country : Korea Sector : Other Non-sector Specific L/C Number : L4302 Partners involved : Prepared by : Michael R. Lav, OEDCR Reviewed by : Anwar Shah Group Manager : Ruben Lamdany Date Posted : 08/19/1999 2. Project Objectives, Financing, Costs and Components : Objectives : (1) Macroeconomic Framework : Restore financial stability and resumption of robust, sustained growth, (2) Concerning financial sector reforms : (a) Strengthen regulatory and institutional framework, (b) clarify processes for evaluation and closure of merchant banks to ensure only viable banks are allowed to operate, (c) resolution of Korea First bank and Seoul Bank, (d) Improve quality of data on commercial banks, assess their viability, and "take enforcement actions", (e) Improve transparency of Government support by appropriately recording all public support of troubled financial institutions and corporations, clarifying procedure for public support, and enforce sound principles for KAMC and Bridge Bank, introduce market -based bankruptcy procedures and facilitate efficient liquidation of insolvent corporations, (f) to improve capital markets, implement debt market reform by reducing auction of government bonds through obligatory purchases, develop an enabling legal framework to promote mutual funds and private pension funds, (3) Corporate Sector Reforms: (a) Improve corporate governance by amending Law on External Audits and other applicable laws to rationalize the institutional framework for setting standards, regulating and overseeing the accounting and auditing profession so that an independent KICPA is responsible for setting up standards and regulating the profession, (b) announce that financial statements of listed companies, banks, and other financial institutions and joint stock companies with assets in excess of 7 billion Won will be required to be prepared and audited in accordance with standards consistent with international best practices and standards beginning with 1999, (c) promote effective monitoring of corporate performance by boards of directors and shareholders, (d) introduce market-based bankruptcy procedures and facilitate efficient liquidation of insolvent corporations by amending laws, (e) enhance competition policies by Korean Fair Trade Commission (KFCT) publication of information on chaebol divestitures and restructuring and provide the Bank with detailed report of all such cases, (f) strengthen operational capacity of KFCT, (4) Improve Labor Market and Social Safety Net (a) (i) allow operation of private manpower leasing services, (ii) relax legal restrictions on private provision of job placement services, (iii) expand coverage of Employment Insurance System to firms with fewer than 5 workers, (iv) ensure financial sustainability of the Unemployment Benefit Scheme, (v) secure funding for retirement allowance and wage arrears in financially troubled firms, (vi) reduce gender inequality in the labor market by revising regulations imposing on high costs on employment of women such as employer responsibility of paying maternity and related benefits to a fund financed by social insurance contributions, (b) Improve poverty monitoring and improve targeting of antipoverty programs, (c) improve the pension system by securing income support for the elderly and improving the transparency and efficiency of the pension fund, (d) Improve Economic Management and Institutions by (i) reorganizing economic policy functions between the Ministry of Finance and Economy (MOFE) and the Office of the President, and (ii) improve debt and asset liability management . Financing : One tranche IBRD loan of US $2 billion Costs and Components : Balance of Payments assistance US$ 2 billion. The loan was approved by the Board and declared effective in March, 1998, and closed on August 31, 1998. 3. Achievement of Relevant Objectives : (1) Marcoeconomic framework: GDP, after declining by 5.8% in 1998, is now projected to increase by 4.5% in 1999, while reserves are projected to increase from the equivalent of 5.1 months of imports to 6.5 months of imports, and the ratio of external debt to GDP to decrease from 46.6% of GDP to 33.9% of GDP. (2) Financial Sector Reforms: (a) some prudential regulations were strengthened and disclosure standards were imported, but "a substantial work agenda remained for SALII, (b) 16 distressed merchant banks were closed, and the 14 which remained open were subject to closer supervision, (c) The Korea First Bank and the Seoul Bank were nationalized and preparations begun for sale to international financial institutions GOK wrote down existing shareholders' stake in the two banks to less than 10 percent of their original stake, and injected new capital . (d) The Financial Supervisory Commission (FSC) was assigned responsibility for dealing with financial distress, while the GOK provided support to commercial banks via the purchase of non -performing loans by the Korea Asset Management Corporation (KAMCO) in a transparent manner. Improved data on commercial banks showed that of the 12 commercial banks which failed to meet capital adequacy requirements at year -end 1997, 5 failed to produce plans which met standards, and they were closed with their assets transferred to stronger banks, while the remaining 7 pursued acceptable restructuring programs. (e) KAMCO pursue sound practices, (f) GOK liberalized the rules for capital market investment by eliminating the restriction (4 percent) on foreign bank ownership of commercial and merchant banks . GOK opened domestic bond market to foreign investors and allowed them to purchase money market instruments issued by nonfinancial institutions. Rules were improved to allow pension fund investments in capital markets (3) Corporate sector reforms: (a) the ICR does not mention of amending law on external audits . The GOK committed to establish an independent accounting standards setting boy and strengthen KICPA's role in issuing auditing standards, (b) GOK committed to preparation and audit of financial statements of listed commercial banks, and other financial institutions consistent with international best practices starting in 1999 (but this is only a start). (c) GOK mandated that at least 25 percent of each board of directors be comprised of outside directors . GOK lowered the threshold for minority shareholders to file suits (from 1 percent of shares to 0.01 percent of shares) and for inspection rights (from 3 percent to 1 percent). (d) To improve the insolvency system, a Bankruptcy Act gave district courts authority over involuntary bankruptcy and composition and reorganization procedures, the Reorganization Act expedited the process of setting deadlines, promoting courts' expertise and enhanced the creditors' role by creating a creditors' committee, (e) . A requirement that asset sales by held publicly, not secretly or through swaps with the chaebols, was instituted. (f) measures to strengthen KFCT were announced but not fully carried out . (4) To Improve the Labor market and Social Safety Net: (a) (i) not discussed in the ICR (ii) not discussed in the ICR (iii) Unemployment compensation was expanded to firms with 5 or more workers (previously, applied only to firms with more than 30 workers) (v) Not discussed in the ICR. (vi) Not discussed in the ICR . (b) Poverty monitoring improved and revealed that poverty and increased from 9 to 15 percent. With better information, better targeting was made possible . The Basic Employment Policy Act was passed authorizing the Ministry of Labor to implement unemployment measures including vocational training and financial support to cover living costs and medical care costs for the unemployed . (c) GOK agreed to phase out forced pension fund lending to government . A "Compensation Fund" was funded as a means-tested non-contributory social pension for the elderly, as an interim measure for the National Pension Scheme which was started in 1998 but would not pay out full pensions until 2008. (d) The ICR does not mention reorganization of economic policy functions between the MOFE an the Office of the President, 4. Significant Achievements : Korea has managed to limit GDP declines to 1998, although that decline (5.8%) turned out to be worse than projected in the President's Report, which projected a 1% increase in GDP. The financial recovery has been quite strong, with foreign exchange reserves now exceeding the equivalent of 6 months of imports. The SAL supported substantial banking sector, financial sector, and corporate sector reforms . Pension and unemployment assistance reforms were also significant. 5. Significant Shortcomings : Within the context of a very large agenda, there are several shortcomings, the main ones concerning accounting and auditing reforms. New accounting standards have not yet been issued . It is unclear whether the GOK commitment to strengthen the KICPA's role in issuing auditing standards has been kept . The ICR does not comment on some of the proposed reforms . These may be shortfalls in implementation, or errors of omission in the ICR. Among these are the proposed reforms to address : (i) the Bridge Bank, (ii) the roles of the MOFE and Office of the President (iii) labor market reforms, including allowing operation of private manpower leasing services and relaxing the legal restrictions on private provision of job placement services, (iv) gender issues, including proposals to have a social fund absorb the costs of maternity leave and other costs borne by firms which affect the relative costs of female employment . 6. Ratings : ICR OED Review Reason for Disagreement /Comments Outcome : Satisfactory Satisfactory Institutional Dev .: Partial Modest Although corporate sector, financial sector, and other reforms would qualify for a satisfactory rating, a key institutional reform proposed in the President's report concerning the roles of the MOFE and the Office of the President is not discussed . Sustainability : Likely Likely Bank Performance : Satisfactory Satisfactory Borrower Perf .: Satisfactory Satisfactory Quality of ICR : Satisfactory 7. Lessons of Broad Applicability : (1) The Bank did not adequately monitor nor assess Korea's economy . More diagnostic resources in the years prior to the crisis could have had a large payoff . The Bank should review the mechanisms and resources it is making available for this kind of work. (2) As large adjustment operations like this are pursued, the Bank should step back from the pressures of operations and carefully evaluate progress and shortfalls (see the audit recommendation in section 8). This would give the Bank a more realistic opportunity to draw lessons on the sequencing of reforms in crisis situations, the timing of real sector reforms (which may be lagging in Korea behind financial sector reforms ), and how best to promote a coordinated adjustment which reducing the possibility of a future crisis . (3) The Bank and the IMF gave mixed signals at various times, despite daily contact, as noted both in the ICR and in the borrower's comments. The Bank and the IMF need to work towards even better coordination . (4) For good reasons, the Bank decided on a special pricing formula for this loan . This, however, was not adequately communicated to the Koreans in a timely fashion. Should non-standard pricing be considered in the future, the client needs to be kept fully informed. 8. Audit Recommended? Yes No Why? This SAL should be audited along with the ERL and additional adjustment operations which may be part of this sequence of operations as an integrated audit, to draw out the lessons of this series of operations for Korea, for countries which may find themselves in similar circumstances, and for managing Bank operations . 9. Comments on Quality of ICR : Despite some shortfalls in coverage, the ICR is satisfactory in discussing the broad range of reforms addressed by the SAL.