Opening to Capital Flows and Implications from Korea

Authors: Kyungsoo Kim, Byoung-Ki Kim and Young Kyung Suh

Recent capital flow episodes in Korea and the effectiveness of policy
responses to such capital flows are discussed. Capital account liberalization
has strengthened the linkage between capital flows and financial market
variables even in the short-term perspective. This paper demonstrates that
some capital flows in the form of investment in bonds are driven by
derivative-related trades. Furthermore, capital inflows respond to domestic
financial variables more sensitively when those variables exhibit high
volatility. The effectiveness of various policy measures has been at least
partially constrained. Even monetary policy does not seem an exception, as
transmission mechanism is significantly influenced by capital flows. As seen
recently in the process of international financial unrest propagation, despite
the health of Korea’s economic fundamentals, volatility in capital flows has
sharply increased.
What have we learned from these experiences? First, once the capital
account is liberalized, existence of a sound market structure is an absolute
necessity. In Korea, despite of recent capital flow reversals, the collateral
benefits from financial integration such as institutional development,
financial market development and improved governance has helped to
mitigate the expansion of financial system instability. Second, prudential
regulation and supervision of banks’ external borrowing, especially short
term, need to be further strengthened. Last but not least, capital flows such
as equity investment and FDI, that are less sensitive to macro variables than
debt and borrowings, can prove to be more stable sources of foreign capital.
In that regard, an economic environment more suitable to attracting FDI is
crucial for dealing with capital flows.