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 increased sharply.

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.

I. Introduction………………………………………………………… 1
II. Capital Account and Financial Market Liberalization………… 4
III. Stylized Facts on Capital Flows in Korea…………………… 12
IV. Dealing with Capital Flows, and the Consequences……… 25
V. Conclusion…………………………………………………………39
Reference……………………………………………………………   42
Appendix……………………………………………………………… 45