During the two-year period since the outbreak in August 2007 of the U.S. subprime crisis, Korea has felt its severe effects: Korea’s economy contracted sharply and experienced a liquidity crisis. In 2008, Korea’s economy grew 2.2 percent, less than half of its average growth since the 1997 Asian financial crisis. The International Monetary Fund (IMF) in a recent forecast (2009b) expected shrinkage of Korea’s economy by about 1 percent, although the crisis had bot- tomed out by the end of the second quarter of 2009. During the six-month period beginning in October of 2008 Korea suffered through U.S. dollar liquidity short- ages, which at one point set off a run on central bank foreign exchange reserves. In retrospect there is little doubt that the crisis was mostly panic driven. It is not clear whether Korea’s policymakers diagnosed the overreaction on the part of international financial market participants as the main cause of the crisis and acted accordingly to deal with it, but they set out to thwart a liquidity crunch spiraling into a currency crisis by restoring the confidence of the global financial community in the Korean economy.
Since April 2009, there have been signs indicating a sharp rebound of Korea’s economy. A consensus is now emerging that Korea is likely to recover from the current global crisis well ahead of many other developed and emerging economies. According to the OECD (2009b), Korea will be the fastest-growing economy among its members in 2010. The purpose of this paper is to delineate macroeconomic developments that began from the economic downturn early in 2008, which was in turn exacerbated by a liquidity crunch, and ended with a return to financial stability in the second quarter of 2009. Section II discusses macroeconomic developments leading to the eruption of the liquidity crisis in the third quarter of 2008. Section III focuses on the causes and consequences of the liquidity crisis, and section IV describes the manner in which Korea’s policy authorities responded to it during this period. Section V looks into future prospects of the Korean economy. Concluding remarks are in a final section.