Korea s Experience with International Capital Flows 1. Trends in International Capital Flows Korea s financial liberalization concomitant with its market opening began in the early 1980s, but at that time, they were implemented only in a limited areas and scope. Consequently, there was no significant effect on foreign capital flows. Starting in the early 1990s, however, additional measures to liberalize and open domestic financial markets were planned and introduced into the broader area. As a result, foreign capital inflows surged until the mid-1990s. International capital flows reversed their course in 1998 due to the 1997 currency crisis, and then once again in 2001 after the worldwide IT bubble crash. Starting from 2002, foreign capital inflows began to recover, reaching their highest level in 2004 since the financial crisis. Nevertheless, over the past three years, the amount of foreign capital inflows accounted for 3-5% of Korea s GDP; a figure much lower than 9% recorded prior to the currency crisis. As such, international capital flows have shown volatile movements ever since the opening of Korea s financial markets. Throughout the early to mid 1990s, Korea s liberalization policies focused on the deregulation of the foreign short-term borrowings by Korea s financial institutions, mainly commercial banks and merchant banks, from foreign banks. In particular, during 1990-96, about 52% of total foreign capital inflows were in the form of bank loans. In conjunction with its post-crisis recovery efforts, the Korean government opened its capital markets almost completely. Subsequently, portfolio investment has increased rapidly starting from 1998. Notwithstanding Korea s sizable government and corporate bond markets, however, nearly 80% of portfolio investment has flowed into the equity market, although such trend is seemingly changing recently. Due to heavy foreign equity investments, foreign holdings in the Korea Stock Exchange reached their record high of 42% in terms of market capitalization in 2004. Even as foreign holdings declined to 40% in 2005, the figure was still the highest among all Asian countries. After the currency crisis, Korean banks also did their homework. With the pressure of the government, they reduced short-term borrowing. In particular, their foreign shortterm liabilities reached 228% of the official foreign currency reserves in 1996, but
declined to 31% in 2005. Having said the basic picture now, I would like to elaborate more on the characteristics of Korea s early financial liberalization and market-opening process, which affected international capital flows into and out of Korea 2. Financial Liberalization in 1990s Before I proceed further, let me briefly explain the economic and political background of the 1990s financial liberalization and the measures introduced by the government. The Korean government faced several key challenges in the 1990s. First, there was an increasing external pressure to reform Korea s foreign exchange system and open the domestic commodity and financial market. Specifically, during the mid-1980s, the United States was suffering from huge twin deficits current account deficit and budget deficit. To solve the problems, the United States made an agreement with Japan and Germany to appreciate both the Japanese yen and Deutsche mark and to open their domestic markets. Then, the U.S. turned its attention to Korea, putting more pressure to accelerate Korea s market opening. Second, the Korean government promoted foreign capital inflows to finance Korea s current account deficits that were rapidly increasing in the early 1990s. To achieve this goal, a comprehensive deregulation about foreign capital inflow became necessary. Last but not least, starting from 1994, the Korean government prepared to join the OECD, which further accelerated financial reforms including the wider liberalization of crossborder capital movement to meet the requirements of the OECD membership. Let me list some of those liberalization measures. In 1990, the government adopted the market average exchange rate system, a variant of the managed floating exchange rate system. In 1992 the Korea Stock Exchange was opened to foreign investors with the initial ceiling of 10%, which later ultimately rose to 20% before the currency crisis. In addition, the government started to implement the so-called Three-stage Blueprint for the Liberalization and Opening of the Financial Sector in 1993. The policy named The Five-year Plan for the Reform of the Foreign Exchange System followed in 1994. The key aims of these long-term plans were three-fold: (1) to liberalize interest rates, (2)
promote competition among financial institutions, and (3) liberalize the trade and capital accounts. In 1994, the government allowed banks almost unlimited foreign short term borrowings. At the same year, Korean individual and institutional investors could start to invest in foreign capital markets with some investment ceilings, which were completely lifted by 1996. In 1994 and 1995, the ceilings of CB, BW and DR issued overseas by domestic companies and banks were vastly raised. In 1995, types of companies that could directly borrow form foreign banks were expanded to small and medium sized enterprises and state-run companies. Overall, the process of the financial liberalization and opening until 1997 can be characterized in the following points. First, while the government made a gradual approach, it was both passive and reluctant in implementing the plans. Even though domestic or foreign demand and the necessity to reform Korea s financial markets were apparent, the government feared that a sudden influx of foreign capital would lead to the surge in money supply, thereby failing the central bank s monetary policy and increasing inflationary pressure, which has long plagued the nation. Please note that the Bank of Korea, like the US Fed, had been targeting the increase rate of monetary aggregate M2 since 1979, by giving it a tight target band, for fear of inflation. Second, changes in the nation s current account balance shaped the liberalization process. Until the mid-1980s, foreign borrowing or capital-raising was encouraged to finance Korea s chronic current account deficits. Even overseas issuance of CB, BW and DR by banks and companies was allowed in 1985, albeit with ceilings on them. In the late 1980s, however, the government reversed the policy as the current account turned to sizable surpluses and put an upward pressure on the value of the Korean won. As such, regulations on foreign capital inflows intensified, and early repayment of foreign debt was promoted. Entering the 1990s, the current account fell into the deficit again, and as a result, regulations on the foreign borrowing were lifted. Third, the main priority in the financial liberalization and opening was given to shortterm instruments. Bank lending rates and corporate bond yields were freed up in the early 1990s, but the government s interference and influence remained until 1996-1997. In contrast, the rates of commercial papers became unrestricted in 1991, and in effect, were determined by the market from 1993-94. For this reason, commercial papers, a
representative money market instrument, became the preferred financing instrument for many companies. Specifically, until the mid 1990s, Korean companies that were on high demand for capital due to their insatiate investment activities had always been searching for the easy sources of capital regardless of the costs of capital. As commercial papers were well digested by non-bank financial institutions, such as merchant banks, these became the favored instruments for companies. In the process of capital account liberalization, the similar story went on. The government first removed regulations on the short-term foreign borrowing (mainly by banks), but kept the longterm foreign borrowing and equity investments by foreigners under its direct or virtual control until the 1997 currency crisis. The government considered that the short-term foreign debt is safer primarily because its repayment occurred more frequently, and hence had a limited influence on domestic money supply without endangering the BOK s monetary policy. Hence, Korea s liberalization moved into an opposite direction from the OECD recommendation, which encouraged the long-term capital liberalization in the first place, prior to the short-term capital liberalization. As a result, both commercial and merchant banks borrowed heavily from abroad in order to take advantage of much lower interest rate of foreign countries. Finally, I would like to point out the incompetence of prudential supervision. Until the currency crisis, the Bank of Korea supervised banks, while the Ministry of Finance and Economy (MOFE) supervised non-bank financial institutions. The Bank of Korea put more efforts into checking whether banks followed the government s lending guidelines instead of scrutinizing the risk management of banks. The MOFE was not performing any better. Its expertise and human resources were in such shortage that it was unable to effectively supervise financial institutions. The wrong direction in the government s policy and the lack of proper supervision resulted in the deterioration of the financial soundness of financial institutions and companies. Financial institutions accumulated a huge foreign debt. In particular, merchant banks borrowing in foreign currencies was excessive compared to their size, which was possible through insufficient regulation and supervision of authorities. More problematic was that banks typically borrowed short from abroad through means such as 3-month credit line and then lent loan to companies with maturity up to 3 years, causing a typical case of mismatching.
3. Korea s Currency Crisis of 1997 In retrospect, several signs of the impending currency crisis have appeared in 1996 and early 1997. First, the GDP growth rate declined to 7% in 1996, and 6% in the first quarter of 1997 from around 9% in 1994-1995. Second, the current account deficit aggravated from below 2% of GDP in 1994-1995 to 4.7% in 1996. Third, starting in the early 1997, bankruptcies of large companies continued, which was unusual in Korea because for several decades, as the high growth of the Korean economy had seldom made companies investment mainly financed by bank loans unsuccessful. No wonder, Korean companies debt-to-equity ratio stood at around 400% at the time. Hanbo, a steel conglomerate, which was ranked 14 th in Korea in terms of assets, went bankrupt in January 1997. Kia Motor, the third largest auto company at that time, suffered from liquidity problems in June. Beside these two firms, additional seven large companies went bankrupt in 1997. As a result, concerns about the fragility of the financial soundness of Korean companies and the financial institutions surmounted among foreign investors and lenders. Currency crises swept through Southeast Asian countries in the second half of 1997. In response, foreign banks requested Korean merchant banks to pay back their dollardenominated loans. Since almost all of those funds had been changed to the won and lent long to companies, merchant banks had to buy dollars in the domestic exchange market to pay back their loans. The KRW/USD exchange rate soared, prompting foreign investors to dump their Korean stocks and exit the Korean market. To pacify foreign lenders, the central bank generously provided banks with emergency dollar loans out of its official foreign currency reserves. Yet, the exodus did not stop, and the official currency reserves fell from over US$ 30 billion to US$ 7 billion within a one-month period. In November 1997, the nation asked the IMF to come to the rescue. The IMF then arranged a US$ 57 billion bailout loan package for Korea As I mentioned earlier, one of the most important causes of the currency crisis was the Korean government s ill-management of the market opening and liberalization process. Due to its favor for banks short-term foreign borrowing, nearly 60% of Korea s total external liabilities consisted of short-term debt in 1996. This already spelled out a sure coming of the currency crisis. The post-crisis period witnessed almost complete liberalization of Korea s capital
account, accomplished by a strengthening of prudential supervision and greatly improved national foreign currency liquidity. New prudential supervision standards included regulations on banks maturity mismatches in their foreign currency assets and liabilities. With substantial current account surpluses and massive inflows of foreign capital into Korean equities, the Korean private sector has also paid down its foreign or domestic debt. Most notably, Korean companies debt-to-equity ratio has dropped to 83% in 2005, which is the lowest among all the OECD member countries. At the same time, the increase in official foreign currency reserves amounting to over 220 billion has left Korea with an ample sovereign liquidity. Following the crisis, the Korean government relaxed most of the remaining restrictions on capital account transactions. Restrictions on foreigners stock investment were completely lifted in May of 1998. A month later, in June of 1998, minimum qualifications for issuers of foreign currency-denominated securities and restrictions on the use of the proceeds were dropped. In the following month, minimum maturities for companies bonds issued overseas were reduced from three years to one year. In contrast to some other Asian countries that experienced the currency crisis, Korea has also substantially liberalized its foreign exchange control. The new law that took effect in April of 1999 marked the transition from the so-called positive system to a negative system. Prohibitions on non-resident deposits with less than one year maturity in the form of the Korean won were removed in January of 2001. Korea s reconstituted banking supervisory authority named the Financial Supervisory Commission introduced regulations to limit the maturity mismatches in banks foreign currency accounts. 4. Lessons Learned Several lessons in managing international capital flows can be drawn from Korea s experiences. Domestic financial deregulation and capital account liberalization may be dangerous with the presence of high leverage in the corporate sector and poor banking supervision. Maintaining a balanced liberalization is important to the maturity of instruments. Authorities should have recognized the externalities of banks reliance on short-term foreign debt and taken steps to limit them. To make an analogy, before you open up a window on a summer night to take fresh air into your room, you d better be prepared with a good mosquito net and insect killers. Obviously, Korea was not.
Today, Korea is facing new set of challenges. Due to the almost complete market opening in 1998, Korea is experiencing an unprecedented influence of foreign capital in various economic areas. Foreign banks have taken 27% in total share of Korean banking industry, and foreign shareholding of domestic banks has reached more than 60%. Domestic banks are criticized since they were reluctant to corporate lending while overly extending household credit in pursuit of excessive commercialism. Bank lending has been essential in Korea s economic development but now that role is weakening. They are also blamed for the heavy debt burden of households. Many critics argue that such changes in banks lending behavior were mainly due to the heavier weight of foreign shareholders in them. Another challenge is how to upgrade the capability of supervisory authority. Recently, more complicated financial instruments have been introduced in Korean markets by increased presence of foreign banks and shareholders. However, the risk assessment on these instruments is not deemed to be sufficient, yet. Making a balance in the treatment of domestic capital and foreign capital is also difficult challenge for the government. To recover form the financial crisis, the government implemented policies favoring the foreign capital. For example, most of regulations on hostile or friendly takeovers by foreign capital were removed, while domestic capital still faces a number of restrictions. Ultimately, notwithstanding the rising concerns about foreign capital, there is no doubt that Korean financial markets will continue to integrate into global financial markets. The Korean government should proceed further with financial liberalization measures as planned. Instead of trying to directly manage foreign capital flows, the government should focus on how to improve the competitiveness of domestic financial institutions and efficiently adapt market participants to changes in business conditions caused by accelerating globalization. Again, a good mosquito net and insect killers are must for anyone who wants fresh outside air on a summer night.