Effects of Capital Flows on Domestic Economies

Capital inflows may result in an increase in asset prices and appreciation of the nominal and real exchange rates. In this section, we summarize the main mechanisms. Capital inflows can affect asset prices in three ways. First, foreign portfolio inflows can directly affect the demand for assets. For example, capital inflows into the stock market increase the demand for stocks and consequently inflate the stock price. In addition, portfolio inflows may affect other markets. For example, as capital flows into the stock market, the stock price increases but the expected return on stocks may decrease. As a result, investors may seek higher returns on other asset markets, such as the real estate market and the bond market, putting upward pressure on other asset prices.

Second, capital inflows may lead to an increase in money supply and liquidity, which in return may boost asset prices. Capital inflows tend to boost the nominal and real exchange rates. To avoid exchange rate appreciation, monetary authorities must intervene in the foreign exchange market. They can cope with excess demand for local currency (due to capital inflows) by buying foreign currencies following such inflows. This results in an accumulation of foreign exchange reserves and accordingly, of domestic money supply. When this leads to an increase in liquidity flows into asset markets, asset prices may surge. The foreign exchange intervention may be sterilized through sales of government securities in an open market operation. However, if the sterilization is only partial, liquidity and asset prices may increase.

Third, capital inflows tend to generate economic booms in a country and to lead to an increase in asset prices. Past studies have documented that economic booms often follow capital inflows. The monetary expansion following capital inflows can lead to economic booms. Capital inflows following a fall in the world interest rate can lead to consumption booms and investment booms. A falling world interest rate also leads to decreases in the domestic interest rate, which may lead to investment booms. For a debtor country, a fall in the world interest rate induces income and substitution effects, which can lead to consumption booms.

Capital inflows tend to appreciate nominal and real exchange rates. In a floating exchange rate regime, foreign portfolio inflows directly affect the demand for domestic currency assets, leading to an appreciation in the nominal exchange rate. Combined with sticky prices, the real exchange rate can also appreciate. On the other hand, if the monetary authority intervenes in the foreign exchange market, the nominal appreciation may be averted in a managed floating regime. However, the real exchange rate may still appreciate. As discussed, consumption and investment booms are likely to increase the price of non-traded goods more than the price of traded goods because the supply of non-traded goods is more limited than that of traded goods.

Next, we will analyse the impacts of capital flows and current transfers on domestic liquidity, credit, exchange rate, inflation and the real sector of the Korean economy.

3-1 Trends in Asset Prices

Since the crisis, equity prices in Korea have increased significantly. Since the market collapse in 1997, the upward trend in stock prices has been very clear. As shown in Figure 6, foreign investment in the domestic stock market increased along with the stock price hike until 2000. However, this momentum was reversed in 2000 with the burst of the global IT bubble. In 2003, foreign investment in the domestic equity market reached a record high of $14.4 billion but since 2005, the equity inflows have declined significantly due to the global rebalancing from the sub-prime mortgage crisis in the US.

While the upward trend in stock prices began on a large scale in 1998, a downward trend in bond yields generally started in late 1999. This trend may have been influenced, among other factors, by spillover effects from equity markets. Most foreign capital flows enter the stock markets, partly because Korea has relatively few developed domestic bond markets. However, as stock prices rise, expected returns on equities drop and bonds become more attractive to local investors, who bid up bond prices, lowering bond yields.

The real estate market has also been influenced by the equity market boom since the crisis. Like the bond market, the real estate market substitutes equity investment for better rate of returns, not only to domestic investors but also to foreign investors. At the same time, the wealth effects from equity price hikes and liquidity effects from portfolio inflows contribute to the price hike in real estate market. Figure 11 [ PDF 18.4KB | 1 pages ] shows the land price index of the Seoul metro area. Since late 1999, the real estate price has increased steadily. The price index has rapidly increased during the last four years, up to almost 40 percent in 2007.

Figure 9: Korea Stock Price Index [ PDF 42.9KB | 1 pages ]

Figure 10: Government Bond Yield [ PDF 42.9KB | 1 pages ]

3-2 Exchange Rate, Liquidity and Foreign Reserves

Portfolio inflows are closely tied to the movements of exchange rates. Under a floating exchange rate regime, foreign portfolio inflows can directly affect the demand for domestic currency assets, leading to an appreciation in the nominal exchange rate. Combined with the sticky price, the real exchange rate can also appreciate. On the other hand, if the monetary authority intervenes in the foreign exchange market, the nominal appreciation can be avoided in a managed floating regime. However, the real exchange rate may still appreciate. As discussed above, consumption and investment booms are likely to increase the price of non-traded goods more than the price of traded goods because the supply of non-traded goods is more limited. Therefore, it can be argued that increases in asset prices and exchange rate appreciation in Korea are the result of capital inflows. To roughly check this hypothesis, we examine the trends in various macroeconomic variables.

The won/dollar exchange rate has shown a long-term downward trend since the crisis. The nominal exchange rate has appreciated steadily since 2003. However, the real appreciation started from 2004 (see Figure 12 [ PDF 22.5KB | 1 pages ]).

Figure 13 [ PDF 23.2KB | 1 pages ] shows Korea's foreign exchange reserves. Foreign exchange reserves have increased rapidly since the crisis based on a precautionary demand for foreign reserves due to the crisis. Furthermore, while Korea has been running sizeable surpluses on its current accounts, it has also accumulated large capital inflows as seen in the previous section. The bulk of the current account surpluses and capital inflows have been sterilized and added to reserves, for these countries that want to stabilize either the nominal or real effective exchange rate with the objective of maintaining their export competitiveness. Although the sterilization of reserve accumulation was substantial, money supply (M2) also seems to have increased sharply in Korea, which may imply that the sterilization was only partial.

In general, these data provide some support for the hypothesis that surges in portfolio inflows led to increases in the asset prices and nominal exchange rate appreciation in the 2000s. The timing of the surge in portfolio inflows and the asset price increase and exchange rate appreciation all coincide. In addition, during the same period, although foreign exchange reserves increased (which suggests some sterilization), money supply also increased (which suggests that sterilization was only partial). There was an economic boom, although there were no consumption and investment booms. The nominal exchange rate appreciation can be justified by capital inflows. Monetary expansion, along with portfolio inflows and the economic boom, may have contributed to the increase in the asset prices.

However, some other factors may explain the asset price increases and exchange rate appreciation in the Korean economy. The recovery from the crisis and improved economic prospects may have also led to asset price increases. Monetary expansion and low interest rates, beginning from the recession in the late 1990s and early 2000s, may be other factors that Korea experienced as asset price booms. The exchange rate appreciation against the U.S. dollar can also be explained by a number of other factors. For example, the massive US current account deficit and national debt problem may have led to a depreciation of the U.S. dollar. In the following section, we will attempt to formally assess the effects of portfolio inflows on asset prices and the exchange rates.

There are three important issues related to current capital flows in Korea. First, we will identify the problems of concentrated equity-related capital flows. Even though net capital flows are either nearly balanced or negative in Korea, current capital flows have been dominated by equity-related flows. This will further contribute to the asset price hike, and in return influence other capital markets such as the bond and real estate markets. We will further examine the effects of equity flows in Korea.

Second, global expectations for a depreciation of the dollar due to global imbalances create downward pressure on the won/dollar exchange rate. This is related to the patterns and directions of capital flows in Korea. With the expectation of a depreciation of the dollar, capital gains from investment in Korea are expected to increase. Moreover foreign investors in the equity market do not generally hedge the currency risk from their investments in Korea as long as the downward pressure on the won/dollar exchange rate exists. This will reinforce the appreciation of the won against the dollar.

Third, Korea is currently experiencing a surge in short-term borrowing by foreign banks due to the expectation of the won's appreciation and mismatches in the forward market. Domestic exporters face full currency risks, since most transactions in trade are contracted in terms of the U.S. dollar. Therefore, they purchase forward contracts in order to fix their cash flows in terms of the Korean won (see Figure 14 [ PDF 30.3KB | 1 pages ] and Figure 15 [ PDF 30.3KB | 1 pages ]). This reduces forward swap rates. On the other hand, banks, which intermediate these contracts, are in the opposite position of selling forward contracts to buyers of forward contracts. Since foreign banks have an advantage on dollar-denominated funding in the global market, and the interest rate differential between Korea and the U.S. creates risk-free arbitrage profits (Figure 16 [ PDF 35.6KB | 1 pages ]) by borrowing from abroad and trading forward contract in the domestic forward market. This will lead to a further appreciating of the Korean won.

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