Introduction

Recently, the Republic of Korea (hereafter Korea) has experienced huge capital flows. Gross capital flows have increased almost 38 times from $1.2 billion in 1980 to $49.2 billion in 2006.¹ Among them, capital inflows have increased 11 times from $1.2 billion in 1980 to 14.6 billion in 2006. In the 1980s and early 1990s, bank loans and transfers were the primary source of capital flows, accounting for more than half of all private capital inflows into the Korean economy. However, the recent huge capital inflows have been mostly driven by a surge in portfolio investments. In recent years, portfolio investments have come to make up to 80 per cent of total private capital inflows.

The current surge in capital inflows into Korea has been induced by both pull and push factors related to Korea's new economic environment that emerged following the currency crisis. With low interest rates and dropping asset investment returns due to the economic slowdown in advanced economies, investors' demand for investment in emerging market portfolios began to soar. To these international investors, Korea is seen as a primary investment point. In recent years, the favorable global liquidity condition has contributed to increased capital inflows into emerging market economies including Korea. At the same time, Korea like other major East Asian countries relaxed its regulatory measures on foreign portfolio investment through capital market/account liberalization, further spurring the portfolio inflows.

However, the recent surge in foreign capital inflows and asset price hikes is a major concern for Korea as for other emerging market economies. Capital inflows, especially into financial markets, have surged, exchange rates have appreciated, liquidity in the market has been extended and asset prices have risen. Observing the rapid appreciation of asset and currency prices and huge capital inflows in recent years, policymakers and academics in the region have expressed concerns over the size of the capital inflows, since reversals could cause financial instability and have adverse consequences on the real economy. Given that financial market stability is critical to macroeconomic management, these trends have become significant factors for policy decisions in emerging Asian economies.

However, these countries have limited policy options in mitigating the adverse effects of huge capital inflows. Potential difficulties in policy options involve complicated policy objectives, since there are trade-offs between domestic and external objectives. To discern the potential policy implications of these increased portfolio inflows, it is essential to assess their impact on the region's capital markets. It is also important to understand the context surrounding these capital inflows.

To shed some light on this issue, we investigate the effects of capital inflows on the Korean economy, paying particular attention to asset prices. In Section 2, we summarize the trends in capital inflows in Korea and provide some explanation of the recent surge in capital inflows, with a special focus on portfolio inflows. In Section 3, we discuss the effects of portfolio inflows on asset prices and exchange rates and explain the relationship, based on the data, to discuss various issues on policy options. In Section 4, we perform an empirical investigation of the effects of capital flows in the economy based on a VAR model. Lastly we identify lessons from the Korean experience on managing capital flows, policy challenges, and appropriate policy responses at the national and regional levels.

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