1999 Menghean financial crisis
The Menghean financial crisis was a financial crisis that affected Menghe in 1999, with lasting effects into 2000. It was brought about by excessive lending among state-owned enterprises, combined with accelerating inflation and a devaluation in the Inminpye, all of which combined to produce a large number of non-performing loans and a flight of foreign investors.
Menghe ultimately weathered the crisis with a two-percent GDP increase for 1999, not technically a recession but still severe in comparison to sustained GDP growth rates averaging 10 percent for the last eight years. It led to a major re-evaluation of Menghe's reform process, with the government privatizing or disbanding the worst-performing state-owned enterprises while simultaneously strengthening the state's regulatory role.
Background
Inflation
Between 1993 and 1998, annual CPI increases of 5-10% became the norm in Menghe. This was partly the result of the country's rapid economic growth, as real GDP increases averaged above 10% per year during this period.
It also reflected a deliberate tolerance for inflation on the part of Cho Ha-jun, the Minister of the Economy. With inflation high but interest rates at state-owned banks low, real interest rates were consistently negative. This meant that borrowers had easy access to credit when expanding their operations, while savers - including ordinary citizens with higher incomes - had every incentive to invest in durable goods or local credit circles, or even start their own enterprises, rather than storing hard cash at home. Because Menghe's banks were all state-owned, their lack of profitability was not a problem, and in effect they served as channels through which the state could direct investment and subsidies.
To limit inflation's negative effects, the government maintained price controls on staple foods, like rice and wheat, and on key industrial inputs, like coal, oil, and electricity. These prices were scheduled to increase at predictable rates, generally 5% per year. Because the producers of natural resources were state-owned, losses could easily be compensated from the national budget, while staple grain farmers were paid generous subsidies.
Exchange rates also remained relatively stable, even after the government allowed the Inminpye to float within a limited range in 1997. Inflationary pressure at home was buoyed up by Inminpye buying among investors, leading state policymakers to believe that free currency trading would not produce instability.
Foreign investment
As early as 1990, the Menghean government had already set up a special economic zone in the city of Sunju, with another for the city of Donggyŏng following in 1991. Six more cities joined the list in 1995. Even though private-sector reforms had barely begun at that time, foreign companies were allowed to operate in SEZs with few major restrictions, a measure intended to improve trade and investment.
Financial reform in 1996 allowed foreign investors to directly issue loans to Menghean companies, providing another route for cooperation and capital inflow. To bypass Socialist regulations, these loans were usually processed by specialized import-export companies, then directed to local governments, and then to the firms in question. Because it avoided the difficulty of setting up firms directly, this became a popular alternative for foreign speculators, especially as Menghe's economic growth soared to new heights.
The use of importer-exporters as mediators, however, added an extra level of obscurity, making it difficult for foreign investors to assess the quality of loan recipients. Foreign capital was often allocated to state-owned enterprises on the basis of political connections rather than profitability, and by 1998 it was becoming clear in inner policy circles that a large number of these loans could not be repaid at the specified interest rates.
Crisis
Domestic origins
The road to the crisis itself began in January 1999, when Jo Ha-jun released a vaguely worded statement to the effect that it would "follow through with planned price reforms" in the coming year. This set off a panic among the general population, as many took it to mean that the subsidized price ceilings on staple foods would expire at a time when real incomes were already in decline. A surge in stockpiling failed to bring about actual food shortages, but it did cause prices across the board to skyrocket, rising 15% in the first quarter of 1999 alone.
Struggling to put out the increasingly burdensome raw material subsidies, in May the Ministry of Economic Planning ordered an increase in coal, gas, and energy prices, which had already fallen well behind the general price level. This intensified inflation, and raised input costs for manufacturing enterprises. Notably, however, it did not pull the subsidies for staple foods, and even expanded subsidies to "quasi-staple" goods like cooking oil, eggs, and sugar.
Investor responses
In response to the surge in inflation, the international exchange value of the Menghean Inminpye abruptly tumbled on August 17th. The profits of overseas businesses in Menghe's special economic zones were effectively wiped out overnight, as they were now worth less than investments at higher exchange rates. Fearful of another exchange rate drop, foreign investors began to convert Inminpye savings to harder currencies while they still could, causing the exchange rate to fall even further.
This development put many of Menghe's own borrowers in a threefold credit crunch. At a time when the Menghean government was struggling to afford its price subsidies, foreign loans were increasingly hard to find, and foreign loans already borrowed had to be paid at steeper expensive exchange rates. Moreover, all of this happened at a time when input costs were rising across the board, and to companies that had struggled to make a profit even before the crisis. Within weeks, Menghe accumulated a large number of non-performing loans, and local SOEs began to default on their obligations by declaring bankruptcy. This set off another flight of investors in September, and brought the value of the Wŏn to an all-time low at less than half its pre-crisis value.
Government responses
Desperate to stem the outflow of foreign capital, Cho Ha-jun ordered the Menghean Central Bank to buy up any non-performing loans left in the public sector, ensuring that no more defaults would take place. He also took emergency measures to tighten the money supply, including the forced sale of government bonds to Jachi-hoesa enterprises. In all, only 27% of foreign capital was subject to default.
By Spring of 2000, inflation and exchange rates had stabilized, and the worst of the crisis appeared to be over. Yet concerns remained about the sustainability of government-held debt, which had nearly doubled over the course of the major buy-outs. International rating agencies downgraded Menghean government bonds, driven in part by fears of a mass default, hardline Socialist retrenchment, or even regime change.
Against this background, the Menghean government surprised investors in September 2000, when it announced that it would surrender its territorial claim to the Renkaku Islands in exchange for debt forgiveness from New Oyashima. Oyashimese investors had been heavily involved in Menghe prior to the crisis, and were reassured to know that they would receive compensation from their own government. The agreement also affirmed Menghe's own interest in maintaining good relations with its trading partners, and warded off fears of a second mass default.
The remaining non-performing loans held by the state were transferred to specialized asset management companies, many of them newly created in the wake of the crisis and run with state input. After going through a period of stabilization, the Inminpye was pegged to the OS Dollar in February 2000, at a constant rate of 24:1. The Ministry of Economic Planning also organized a sell-off of the least profitable state-owned enterprises, predominantly mid-size factories run by city or county governments. Reassured that an aftershock crisis was unlikely, foreign investors began returning to the country.
Political effects
The 1999 financial crisis ushered in a brief period of political instability, and nearly brought the country's economic reforms to a halt. Party conservatives - that is, those who wished to preserve the Socialist system - argued that the transition to a market system had left the country vulnerable to financial speculation at the whims of foreign investors.
Cho Ha-jun was a particularly vulnerable target, as his inflationary policies had contributed to the buildup to the crisis. Breaking with majority opinion in the Party, Choe Sŭng-min refused to fire Cho, on the basis that he was still the leading economist in the government's upper ranks.
Tensions briefly subsided in late 1999, but broke above the surface again in the summer of 2000, when Choe first proposed at a meeting of the Supreme Council that Menghe should renounce its claim to the Renkaku Islands. Bae Tae-uk, the Vice-Chairman of the Supreme Council, was a particularly vocal opponent of this approach. In November 2000, rumors of a coup in the making spread through Donggyŏng, and military police units were deployed throughout the city to prevent an attack. Bae Tae-uk and a number of other high-ranking conservative officials were arrested, and Choe made it clear that he would firmly stand by any economic reforms.
This inner-circle quarreling did not spill over into the mass public sphere, in part because of emergency measures taken to limit the effect of price hikes on vital goods. Even as the prices of industrial inputs rose, the state did not relax price controls on staple foods, and continued to subsidize producers of these goods.
Ultimately, opposition within the Party dissolved for pragmatic reasons. By the end of 2002, annual GDP growth had reached 10.9%, and CPI inflation remained manageable at around 4%. Foreign investors were returning to the country, and Menghe's economic future was no longer in doubt. From this point onward, the reformist faction enjoyed undisputed support within the Menghe Socialist Party, and was free to further promote the growth of the private sector.
Nevertheless, Cho Ha-jun resigned from his post in 2003, instead applying to work as a professor of economics at Donggyŏng Central University. After his resignation, the massive Ministry of Economic Planning was divided into two smaller agencies, the Ministry of National Economic Development and the Ministry of International Trade and Investment.
Long-term reforms
While the 1999 financial crisis failed to bring about hardline Socialist retrenchment, it did create newfound caution about the risks of foreign investment. To stabilize exchange rates, the government kept the Inminpye at its 24:1 peg with the OS dollar, and showed a considerably more cautious approach to inflation. It also strengthened regulations throughout the economy, cracking down on unlicensed private banks and requiring a stricter review of local investments. Vast numbers of mid-size state owned enterprises, which had been particularly burdened with non-performing loans, were sold off to private owners or permitted to go bankrupt. Once the privatization process was finished in 2006, the only remaining state-owned enterprises were large, centralized firms dealing in natural resources, utilities, and telecommunications.