(FORTUNE Magazine) – The way Western companies are charging into South Korea these days, you'd think the Asian financial crisis had never happened. General Motors, eager for a low-cost production base in Asia, is negotiating a potential multibillion-dollar deal to buy up to half of Daewoo Motor, Korea's second-biggest automaker. The German chemicals manufacturer BASF is acquiring three Korean operations for a total of around $700 million. And Saudi Prince Alwaleed bin Talal--a major shareholder in Citicorp and Apple Computer--has plunked down $200 million for bonds convertible into big chunks of Korea's Daewoo Corp. and Hyundai Motor.

It's easy to see why international investors are being drawn to Korea once again. The nation's political leaders have embraced the conditions for change tied to the IMF's record $58 billion bailout package. President Kim Dae Jung, 74, the charismatic social democrat who took over in February, has persuaded militant labor unions to accept the inevitability of layoffs. He has even persuaded the chaebol, those large family-run conglomerates that dominate Korean business, to change their parochial habits. Daewoo, Samsung, and others are adopting transparent accounting practices, respecting the rights of outside shareholders, and liquidating unprofitable businesses. Moves like these should help attract foreign investment, which, says Kim, "is a matter of life and death."

So far the world's financial community likes what its sees. In early April, Korea, saddled with $151 billion of foreign debt, enjoyed surprisingly strong demand for its $4 billion bond sale, the first issue it's floated since the Asian crisis hit last fall.

Yes, Korea has made impressive progress, but anyone who thinks that the country is only a couple of years away from a full-blown recovery is dramatically underestimating the depth of its problems. For one, the Korean economy is likely to get a lot worse before it gets better. Last year its GDP grew nearly 6%, but now it's shrinking. The chaebol are gasping for cash, and bad debts still threaten to swamp the banking system. Unemployment is approaching 6%--the highest level in 14 years--and climbing fast. In recent weeks, President Kim had to threaten to take "dramatic measures" to deter social unrest as "100 businesses go bankrupt a day, and 10,000 workers lose their jobs daily."

In response to tough economic times, Koreans are curbing their consumption. Companies are trimming salaries of senior executives by 15% and removing half the fluorescent light tubes in offices. People are postponing purchases of cars, clothes, and jewelry. Stores, their windows pasted with IMF SALE signs, are suffering badly.

If Koreans stop buying, however, that will only strangle an already illiquid economy. To jolt Koreans out of their extreme austerity, the government now sponsors tongue-in-cheek TV ads that show an unhappy woman tightening her belt and gasping: "Go naked, don't eat, don't drink, don't breathe."

Nor can Korea count on an influx of foreign capital to bail it out. True, companies like GM may hope to buy into Korea, but don't expect a flood of direct investment anytime soon. The nation has a long history of resisting outside capital, even when it is desperately needed. Anti-foreign feelings, honed during 42 years of harsh Japanese rule that ended in 1947, still run deep. That xenophobia particularly infects the entrenched Korean bureaucracy. Early this year Dow Corning, frustrated by yards of red tape, abandoned two years of difficult negotiations to obtain approval for a $2.8 billion silicone project. Now it will set up shop in Malaysia.

Some Korean business leaders even pander to a wacky but surprisingly popular notion that an international conspiracy wrecked their economy. As Chairman Lee Kun Hee of the Samsung Group has told his troops: "The advanced nations have had a program ready for managing the Korean economy, and they simply were waiting for the right time to implement it."

To Lee and many others, Korea's plight amounts to economic warfare. "Driving imported cars is currently perceived as unpatriotic among many Koreans," says Choi Byung Kwon, chairman of the Korean Automobile Importers and Distributors Association. Owners of foreign cars, barely 1% of the Korean market, are often the targets of vandalism, and some service stations refuse to sell them gas. Used-car lots are now starting to fill up with Mercedes, BMWs, and other foreign models.

With attitudes like these, Korea's chaebol are unlikely to rush into true reform. That's too bad, because it's sorely needed. For three decades the chaebol, buoyed by easy credit, spearheaded Korea's growth. But according to a new study by McKinsey & Co., it was the chaebol that ultimately brought down the economy. Says the report: "The current crisis was largely caused by low capital productivity," not by a mere liquidity crunch late last year.

The chaebol benefited from closed markets. But this protectionism also made them inefficient. As the McKinsey study points out, labor and capital productivity in most Korean industries are at less than 50% of the levels of the U.S. and Japan. Korea's automakers, for example, never adopted lean manufacturing techniques (which build in quality through teamwork in factories)--and thus produce only half the number of cars that Japan does in comparable plants.

To achieve world-class results, Korea's top business groups will need to spin off their doggy businesses and start focusing on making their operations more efficient. Remarks Yong Sung Kim, a Wharton MBA and senior consultant at McKinsey in Seoul: "It's impossible for the chaebol to retain the old structure anymore with 20% interest rates on borrowing, many short-term loans, and low profitability."

Already there are some signs that Korea's business leaders are starting to move in the right direction. The Samsung Group, for instance, has enlisted Goldman Sachs for advice on unloading innumerable marginal businesses, ranging from an aerospace manufacturer to the luxurious Shilla Hotel in Seoul. With little fanfare, the LG Group, best known for chemicals and electronics, is trying to dispose of 90 operations that its executives won't identify but claim are worth a total of $1.5 billion. Says Chong S. Lee, a senior managing director who is LG's point man for restructuring: "Sometimes you must control your appetite by knowing what you do best and what you should give up."

Despite all the strong rhetoric about pruning operations, many investment bankers doubt that the chaebol will go far enough. Most notably, Samsung Chairman Lee seems unwilling to abandon an obvious candidate for liquidation: his cherished Samsung Motors, a new automaker that made an ill-timed $1.8 billion investment to enter an overcrowded industry. With a hint of desperation, the company keeps firing off press releases about a potential rescue by Ford Motor, which seems decidedly cool to the idea. As one Ford official in Dearborn, Mich., puts it, "We are a long way from reaching any agreement."

Another factor likely to slow down the restructuring: Korea's habit of asking sky-high prices for its assets. Volvo, for instance, has signed a letter of intent to purchase most of the unprofitable construction-equipment business of Samsung Heavy Industries. Says Jeong Ja Lee, head of research at HSBC Investment Bank in Seoul: "Samsung wants $700 million for that business, but to foreigners that's nonsense." She figures that the true value of the deal may be $300 million to $500 million. Lee, in fact, advises foreign shoppers for corporate assets to come back later this year, "when Korean companies will realize they have a cash shortage and will be ready to make quick decisions at more reasonable prices."

Over the long haul this paring down won't accomplish much unless the chaebol fulfill their promise to focus on shareholder value. Many of them never fully report their results. Some use strong companies to subsidize weak ones, and others cover loses by revaluing their real estate holdings. Scrutiny from outside shareholders is unheard of. As the McKinsey report puts it, "These practices prevented managers and their creditors from understanding the true performances of their businesses."

All that's starting to change. Companies say they will adopt international accounting practices. Among other things, this means cleaning up the balance sheets. Over the next several years the chaebol must find ways to dramatically lower debt-equity ratios averaging 350% to levels closer to those of U.S. corporations. These conglomerates also have to dismantle some $4 billion in cross-guarantees of debt among companies in each group.

For the first time ever, outside shareholders are beginning to have a say in how Korean companies are run. For example, American investors, led by the New York-based hedge fund Tiger Management, just staged a successful revolt at SK Telecom, the country's leading cellular phone operator. The outsiders forced the phone company to stop subsidizing its sister companies in the SK Group. The conglomerate had been using the telecom operator's handsome cash flow as a piggy bank for its other separately owned companies--long a standard practice in Korea. SK Telecom, for instance, backed a $50 million loan to its sibling SK Securities, which recently suffered heavy losses in derivatives trading. To guard against such maneuvers in the future, minority shareholders demanded--and got--three outside directors on the board of SK Telecom and an independent auditor.

As is their nature, the Tiger fund and other outside shareholders will demand higher profits, and in Korea that of course can mean massive layoffs. The chaebol, which have always offered lifetime employment, are overstaffed as much as 20% by some estimates. Getting into fighting shape won't be easy. Says Richard Samuelson at SBC Warburg Dillon Read: "When two million are unemployed, no one will want to talk about reforming conglomerates that provide jobs."

Though Korean labor unions have promised to cooperate with downsizing, fears of unemployment still spark active resistance. Samsung Heavy's workers, though not unionized, angrily demonstrated at the Changwon factory against plans to sell its construction-equipment operation to Volvo. After production was disrupted for several days in February, Samsung restored calm by guaranteeing their jobs for a year. Remarks Choo Ho Suk, president of the heavy machinery division of rival Daewoo Heavy Industries: "Maybe Volvo will make the deal, maybe not. But whatever is done, there will be problems with those employees."

Daewoo Heavy is taking a more subtle approach to reducing its work force. The company is quietly turning over to outside contractors marginally profitable activities like hammering out auto-engine components. As part of the deal, Daewoo workers get jobs with the supplier. To persuade employees to transfer voluntarily to an outside contractor with lower pay levels, Daewoo sweetens their salaries for a year. Says Choo: "We guarantee orders to the contractor, so employees who transfer at least can be sure of a job."

Laying people off is one survival strategy; finding strong partners is another. Daewoo Chairman Kim Woo Choong, 61, the most global-minded chaebol leader, is pursuing links with such companies as Ansaldo, an Italian shipbuilder and producer of power generators, to obtain both capital and a hedge against protectionism. Says Kim: "With joint ventures we could go into markets under the flags of advanced countries." A hyperactive dealmaker, Kim is working on strategic alliances from Japan to France that he hopes will avoid the need to liquidate any Daewoo operations.

Chairman Kim's biggest coup could be a new joint venture with GM, its former partner for 15 years. They split in 1992 over a clash of ambitions: Daewoo wanted to ramp up production and enter emerging markets around the world while GM mainly considered the Korean automaker as just another factory in its worldwide network.

Since breaking up with GM, Daewoo has poured $6.3 billion into making its auto company a more credible competitor. Says Kim: "I thought that if we could manage Daewoo Motor better on our own, GM would be interested in getting together again." Daewoo Motor has created a full line of its own car models, with help from engineering companies acquired in Britain and Germany. Says Ulrich Bez, 54, a former Porsche engineer who is vice president for engineering and product development at Daewoo Motor: "It takes at least 15 years to become a leading car player, and Daewoo, while not there yet, has already moved to a higher level of creativity and intelligence."

Daewoo Motor has become the most global Korean automaker, with 14 overseas plants in such emerging markets as Poland, Romania, and the Ukraine--the very places where GM sees growth potential. (GM has already arranged to assemble its cars at the Daewoo plant in the Ukraine.) Says Kim: "We have a good strategic fit because GM is strong in advanced countries and we're mainly in emerging markets."

What if GM decides against remarriage? Says the Daewoo chairman, hinting that he also has European suitors: "Others are interested in us, though we'd gain more strength from GM."

In the long run, the odds are that Korea will once again become an economic force. Kim's reforms, if carried out fully and vigorously, should eventually get the country back on the right track. After all, the raw material for success is unquestionably there--a solid industrial base, a diligent work force, and the can-do spirit of the Korean people. As one Korean corporate middle manager puts it, "We'll get through all this because we have no other choice." Just don't expect an overnight miracle.