There is a widespread recognition that the progress in financial globalization was a major factor in causing the spread of the US subprime mortgage crisis to become a global financial crisis. In relation to this, there have been in-depth discussions in the international community on the possible negative influences of international capital flows on financial stability and on measures to curb these influences. As a result, a consensus has formed that restricting capital flows can be appropriate in an inevitable situation such as one necessitating the achievement of financial stability.
Given that the international community had tended to unilaterally support capital liberalization particularly since the Washington Consensus, such a change is definitely a positive sign for emerging market countries. This is because, unlike advanced countries, emerging market countries whose economies have high external dependency have experienced the triggering and propagation of their financial sector procyclicality through the various channels of foreign capital inflow; and banking sector external debt, in particular, which is the main channel for foreign currency funding, shows extremely high in/outflow volatility compared with other types of funds, and accordingly has a larger negative impact on these countries’ financial stability.
Given this fact, in this paper an indicator is developed to reflect emerging market financial stability and by investigating its linkages with the financial situation in advanced market countries, major macroeconomic vulnerability indicators and capital in/outflow variables, an empirical analysis is carried out as to whether banking sector external debt has accentuated financial sector procyclicality and increased financial vulnerability in emerging market countries. This analysis leads to the conclusion that excessive foreign currency borrowings have had an extremely negative impacts on emerging market financial stability, which suggests that emerging market countries, unlike advanced market countries, should, when formulating macroprudential policy, place greater emphasis on enhancing foreign exchange soundness.
In light of this, Korea’s macroprudential policy in the foreign exchange sector can be seen as an exemplary case that reflects the distinct characteristics of emerging market countries. As witnessed in the recent global financial crisis, however, financial vulnerabilities, and above all surges in banking sector external debt, can develop into a sudden crisis triggered by a variety of factors. In this regard, it is necessary to make multi-pronged efforts to develop consistent, sophisticated monitoring techniques to promptly identify signs of
factors making for vulnerability and also to expand policy measures to manage the identified factors in a market-friendly manner.