Policy Finance

Concept and rationale

Policy finance is finance supplied through deliberate government intervention to compensate for private finance's failure to meet financial demand. Its theoretical grounding is market failure: under imperfect and costly information, credit allocation involves unequal distribution of information, monitoring and verification costs, and enforcement costs, so credit is not necessarily allocated to its best use; asymmetries can produce adverse selection, moral hazard, free riding and incentive conflicts. Government intervention in credit allocation is justified under these conditions (Vittas and Cho, World Bank Research Observer, 1996).

History

In the 1950s foreign-aid funds financed economic revival and import-substitution industry. In the 1960s, with the First Five-Year Economic Development Plan, the state took control of the financial system as a whole, converting it into a policy-finance system for exports and strategic industries. In the 1970s policy finance expanded rapidly for heavy and chemical industry through long-term equipment finance and the selective-finance system (선별금융제도), and the policy-finance system under the Monetary Policy Committee was organized in this period. The 1980s were a readjustment period that restructured policy finance into a functional system centred on industrial restructuring. In the 1990s financial liberalization reduced or abolished policy-loan and credit regulations and shifted the main channel from ordinary banks to policy finance institutions, focused on small and medium enterprise finance. The 2000s brought modernization toward a market-functioning model centred on next-generation growth engines, the social safety net, and environment and energy (carbon reduction, renewables).

From the 1960s to the 1970s policy finance operated within the framework of government-directed finance (관치금융). After the May 16 coup the military government enacted the Temporary Measures Act on Financial Institutions and amended the Bank of Korea Act, subordinating interest-rate decisions, credit allocation, budgeting, personnel and organization to the executive; this control continued through export-finance privileges and low-interest credit allocation until the Temporary Measures Act was repealed at the end of 1982. The Financial Services Commission labels the 1970s the 'Policy Finance Era': together with the heavy-chemical industry drive came the August 3 emergency measure of 1972 and the institutionalization of curb-market funds, and new policy institutions were established, including the credit guarantee system (Credit Guarantee Fund Act, 1974) and the Export-Import Bank of Korea (1976).

Relations and scale

Korean policy loans accounted for roughly 50 per cent of total credit extended by domestic financial institutions in the 1970s, falling gradually to about 30 per cent in the 1980s, and about 60 per cent of total lending by government-controlled deposit money banks throughout. Only 7 to 8 per cent of commercial-bank policy loans were financed by fiscal funds, and about 35 per cent came from Bank of Korea borrowing. The government also controlled foreign-loan allocation by requiring authorization, and the 1965 revision of the Foreign Capital Inducement Act let government-controlled banks guarantee firms' repayment of foreign borrowing.

The state used tax and financial incentives plus control of the banking system to channel firms into priority industries, and officials, firm managers, bankers and industry associations consulted closely through the presidentially chaired Monthly Export Promotion Meetings and Monthly Briefings on Economic Trends. Banks functioned as the treasury unit, industry as production and marketing units, and government as the central planning and control unit; this large-scale orientation produced overwhelming economic concentration in the chaebol.

Because firms were highly leveraged, the government became an effective risk-sharing and implicit coinsurance partner with industry and banks. The costs of credit intervention, however, were borne primarily by banks and their depositors: commercial banks functioned as development banks, managerial efficiency was compromised, nonperforming loans accumulated, banks had little incentive to screen or monitor because the government was willing to rescue firms, and the chaebol became too large to fail, making later liberalization harder. After the 1997 foreign exchange crisis the government created public funds and carried out financial-structure reform: in December 1997 it agreed with the IMF on a 57 billion dollar support package, suspended 14 merchant banks, 2 securities firms and 1 trust company, set up the Financial Supervisory Commission and amended the Bank of Korea Act. In 1998-99 it ordered corrective measures on 12 banks, exited 5 insolvent banks, revoked licenses, and promoted the Big Deal business swaps among the top five groups.

Distinctions

By implementing institution, policy finance divides into narrowly-defined policy finance and policy-nature finance. Narrowly-defined policy finance covers the Bank of Korea's financial-intermediation support funds (formerly total-limit loans) and policy funds and funds directly supported by the government or government-funded bodies, with concrete goals such as green-company or SME support. Policy-nature finance covers institutions that raise funds in the market themselves, such as the Korea Development Bank, Korea Export-Import Bank, Industrial Bank of Korea, Korea Credit Guarantee Fund and Korea Technology Finance Corporation; they receive no separate government funds but have payment guarantees and non-specific goals, and bear the contradictory identities of public purpose and market viability.

Policy finance is also distinguished from financial repression. Financial repression denotes intervention that suppresses and distorts the financial market in general, allocating funds toward government goals and controlling interest rates, a broader and more negative concept, whereas policy finance is justified as correction of market failure. Policy finance nonetheless carries side effects such as government failure, political interference and agent costs.

Policy-based credit programs were a leading development-policy tool in the 1960s and 1970s, but in most developing countries they failed, creating distorted incentives, capital-intensive projects, diversion of preferential funds, higher costs for non-preferential borrowers, low repayment and swollen deficits, and once introduced were hard to eliminate. Japan and Korea are the relative successes, attributed to economic factors (price stability, export orientation, domestic competition, reliance on the private sector, industrialization bias) and institutional factors (government-business consultation, effective monitoring, credible development plans).

Examples

Instruments after financial liberalization include direct investment and lending, interest subsidy, on-lending, and credit guarantees. In direct investment and lending the government bears funding responsibility and selects recipients. Interest subsidy (이차보전) has a financial company screen and lend while the government subsidizes part of the interest, using market mechanisms but risking moral hazard and market distortion. In on-lending the policy authority supplies funds to financial companies at below-market rates on condition that they lend to pre-selected eligible firms, with the policy finance corporation sharing credit risk up to a certain ratio. Credit guarantees cover part or all of borrowed funds, helping firms with repayment capacity but weak collateral; they notably improve SME access to finance while weakening financial institutions' risk-bearing and information-generation incentives.

Korea's six special banks received government funds and debenture sales, and policy-development institutions supplied credit for business and government projects. The Export-Import Bank of Korea provided medium- and long-term credit for exports of capital goods and services, resource development and overseas investment; the Korea Development Bank raised funds from the government and from international financial institutions and foreign banks to fund key industries and infrastructure; and the Korea Long-Term Credit Bank financed equipment investment.