Policy Options

The Korean government has implemented a variety of policy measures to deal with large capital inflows, including the mitigation of currency appreciation pressure by implementing sterilization methods, prepayment of foreign debt, encouragement of capital outflows, and tightening of credit growth by increasing lending rates and required reserves. Here, we assess the effectiveness of existing policies and measure adopted by the Korean authority to manage capital flows and domestic liquidity.

5-1 Exchange Rate Policy

The effects of capital inflows may vary depending on the exchange rate regime. Although real exchange rate appreciation pressures may increase under both a floating and fixed exchange rate regime, the adjustment under a floating regime is more direct and less costly. This is due to the availability of measures under each type of regime. The primary measure for adjustment under a fixed regime is a rise in inflation which naturally occurs as inflows stimulate domestic activity. Under a floating regime, nominal exchange rate appreciation is an option that can be used to augment adjustment with the additional benefit of discouraging inflows by reducing their returns in terms of foreign currencies. On the surface, adjustment under a floating regime tends to be less stable because of the utilization of the nominal exchange rate in adjustment; however, the effects of these measures may be less detrimental in larger and deeper financial markets.

One way to enhance monetary autonomy is through the implementation of a floating exchange rate regime, which enables monetary authorities to handle fluctuations in monetary aggregates resulting from fluctuations in capital flows with greater flexibility. In addition, the central bank may intervene in the event of a capital flow reversal, curbing financial instability as a safety net lender.

To deal with increasing capital inflows, countries must move more into flexible exchange rate regimes. This would enhance the maneuvering room for monetary authorities in a world of volatile capital flows. However, increasing the flexibility of exchange movements alone cannot cool down an overheating economy or prevent the development of asset bubbles. Allowing more flexibility in the exchange rate is one option, but not the only one. Even though Korea has allowed the exchange rate appreciation, capital inflows still increased in the 2000s.

5-2 Monetary Policy

One way of dealing with capital inflows is to lower interest rates. Lower interest rates tend to reduce capital inflows and reduce appreciation pressures by making interest arbitrage less attractive. However, cutting interest rates may further boost liquidity and add to inflationary pressures, making this option less attractive if inflation is already elevated. At the same time, if asset prices are increasing, lowering the interest rate may boost asset bubbles.

On the other hand, in a time of surges in asset prices, the central bank may indeed consider raising interest rates. How monetary policy reacts to asset prices is highly controversial in general, both from an academic point of view and from a policy perspective. There is wide debate over whether monetary policy should target asset prices. The arguments against it are as follows. First, it is hard to determine the existence of asset bubble ex-ante, and thus, targeting asset prices may destabilize the economy. Second, large hikes in interest rates may be required to prick or burst asset bubbles, and this leads to a substantial recession. Lastly, if a bubble bursts, monetary authorities can respond quickly by providing liquidity to prevent severe asset price falls, and therefore a pre-emptive monetary policy that targets asset prices is not necessary. This is dubbed as a Fed-view (Roubini, 2006).¹² On the other hand, several authors have emphasized that central banks should target asset prices as well as inflation and output gaps. Filardo (2001, 2004) argues that the optimal monetary policy rule implies that asset prices generally enter into the reaction function of the monetary authority. If there is a rising bubble, monetary policy should be tighter than under a simple Taylor rule, while, when the bubble bursts, optimal policy should be easier than under the Taylor rule. Others also insist that highly leveraged asset acquisition fueled by excessive credit creation and asset misallocation may happen even when inflation is low. A monetary authority which focuses on the mean inflation rate alone may thus miss seeing possible growing financial imbalances (Borio and Lowe, 2002, 2004).¹³

It is not obvious that Korea should implement monetary policies that target asset prices in general. However, Bautista (2007) shows that asset price booms matter in East Asia because they affect the probability of the occurrence of adverse macroeconomic development, and insists that pre-emptive monetary policy is required to deal with asset price appreciations in the region. In addition, recent experiences in the United Kingdom, Australia and New Zealand suggest that it is possible to react to the formation of bubbles through a moderate and gradual monetary policy tightening without causing a financial and economic crash.

Korea tightened its monetary policy in 2006 to moderate housing prices. Even though inflation pressures persist due to economic recovery and high oil prices, the Bank of Korea (BOK) raised the benchmark call rate by 25 basis points from 4.25% to 4.50% in August 2006. This implies that even if the BOK is not targeting asset prices directly, it is indirectly considering potential inflationary pressures stemming from asset price appreciations.

However, monetary tightening is a limited policy option in emerging Asian economies, since higher interest rates can stimulate portfolio inflows and create more pressure in liquidity expansion. At the same time, exchange rates will also appreciate. This is not welcomed by most emerging Asian economies since it reduces export price competitiveness. On the other hand, in the presence of strong external inflows, many countries use sterilized foreign currency market intervention to neutralize appreciation pressures on the exchange rate. However, sterilized intervention may not be completely effective, and can lead to increases in domestic liquidity conditions which can feed into asset markets. Even if ineffective, sterilized intervention has some important effects on domestic asset markets. First, the domestic interest rate will be higher than otherwise. With inflows into the domestic bond markets, interest rates will tend to fall but sterilization will at least partially offset the drop. Thus, any gap between foreign and domestic interest rates will persist, encouraging capital inflows to continue. Second, sterilization increases outstanding domestic government bonds, which may increase the size of the public debt. This can undermine the credibility of macroeconomic policy, setting up a potential reversal in capital flows. Third, with sterilization, the monetary authority increases the holdings of foreign currency assets but decreases the holdings of domestic government bonds. This can be very costly because the domestic bonds are likely to provide higher interest payments than foreign currency assets. Fourth, sterilized intervention may hamper further financial reforms. Commercials banks will hold up the central bank's debts. To cut down the cost, a lower interest rate may be applied to the debts. It may eventually increase the burden of commercial banks or turn out to be a control over domestic interest rates.

The monetary authority may increase reserve requirements or the discount rate to prevent the increase in the money supply from reserve accumulation. However, these policies also involve some problems. They can be viewed as more regulation on financial markets— countering financial market liberalization. In addition, they can distort the banking system, for example, if participants discover counterproductive ways to bypass regulations. The Bank of Korea increased the average reserve requirement ratio from 3.0% to 3.8% in December 2006. This led to a slight lowering of the liquidity expansion, as the capacity of financial institutions to provide credit weakened in accordance with the increase in their required reserves.

In general, Asian economies have limited monetary policy options to mitigate the adverse effects of huge capital inflows, and potential difficulties lie on complicated policy objectives, since there are trade-offs between domestic and external objectives. In order to assuage the surges of capital inflows, lowering interest rates may be a good candidate. However, this will increase domestic liquidity and the formation of asset bubbles. At the same time, to cool down an asset price hike, monetary tightening can be considered, but this will put pressure on the exchange rate and exports will be adversely affected.

Nevertheless, current asset price appreciations in the region should be carefully managed by monetary policy at least in the short-run. In countries with huge asset price appreciations, such as China, a moderate short-term interest rate increase can help to alleviate asset price bubbles. A slight increase in the short-term interest rate will affect both credit conditions and decrease leverage and excessive risk taking by investors. This, in turn, will affect asset prices. It will also have a smaller effect on exchange rates if the increase in interest rate is minimal. On the other hand, Thailand and Indonesia, which have experienced a weaker asset price increase but higher inflationary pressure and weak domestic demand, have been able to cut interest rates. It may help to limit capital inflows by bridging the gap caused by the interest rate differential.

5-3 Fiscal Policy

The government can tighten fiscal policy to calm an overheating economy in order to counter some of the effects of capital inflows. In addition, decreasing government spending can reduce the relative price of non-tradables and relieve the appreciation pressure on the real exchange rate. See Eichengreen and Choudry (2005) for a fuller discussion of the use of fiscal policy to offset the effects of capital inflows.

In the East Asian countries that have high inflationary pressure, a fiscal contraction may be an important option since an alternative contraction policy (i.e., a monetary contraction) can cool down the economy but may further attract capital inflows and appreciate exchange rates. Most Asian countries have displayed a generally balanced fiscal position for decades. The average budget deficit in the six emerging Asian economies since 1998 is a mere 1.6%. The Philippines, with the highest budget deficit, reduced its deficit from 5.3% in 2002 to 2.7% in 2005. China's budget deficit has fallen since 2002. All other countries have remained at a lower level of budget deficit. Therefore, it seems that fiscal contraction is not necessary for reducing the fiscal burden. However, tightening fiscal policy can reduce the impact of portfolio inflows by contracting domestic demand, and therefore limiting inflation and real appreciation.

On the contrary, the policy authority should be very careful in implementing fiscal contraction. Fiscal policy is subject to long decision lags, compared with very volatile and unpredictable capital flows. For example, by the time a fiscal contraction is implemented, the surge in capital flows may have subsided. In this case, the fiscal contraction can actually worsen the situation.

5-4 Encouraging Capital Outflows

In principle, one method for curbing disproportionate amounts of unproductive forms of capital inflows is the use of capital controls. In general, capital controls do not appear to be a viable option for curbing the short-run effects of capital inflows in Korea, since Korea liberalized most capital account restrictions in 1998. Alternatively, it can be considered that lifting restrictions on capital outflows by private investors may mitigate the adverse effects of huge capital inflows. Most emerging Asian economies have the potential to further liberalize the restrictions on capital outflows and achieve a greater degree of symmetry in controls on inflows and outflows. As restrictions on capital outflows are lifted, private investors have access to more diversified financial assets. Furthermore, they need not pursue limited investment opportunities in the domestic market. This may reduce the upward pressures of exchange rates and prevent asset bubbles from forming in the domestic capital market. However, countries should be careful in removing restrictions on capital outflows since it can aggravate the situation at the time of reversals in capital flows.

Korea has encouraged overseas investment by financial institutions and individuals to mitigate the negative effects of the huge capital inflows into the domestic capital market. In 2007, a temporary three-year tax exemption will be applied to capital gains generated from overseas stock investment by domestic investment trust and investment companies. The government has also eased regulations in order to boost overseas real estate investment through indirect investment. For example, the acquisition limit on overseas real estate by domestic residents for investment purposes will be raised from the current US$1 million to US$3 million.¹⁴

5-5 Financial Market Regulation and Supervision

If a government cannot directly control capital inflows and is concerned about an excessive appreciation of asset prices, strengthening financial regulation and supervision should be considered in order to prevent asset bubble bursts. When there is excess liquidity and lower interest rates in the market, it is highly plausible for economic agents to take risk investments. The government should access and influence risk-taking behaviors by financial institutions through a range of qualitative and quantitative methods. These measures include restrictions on portfolio composition, risk-based capital requirements, loan loss provisions, and stress testing of market risk exposures. Concerns can then be addressed using regulatory measures directed at specific asset markets. This will be all the more effective if a large portion of the funds flowing into asset markets derives from domestic agents. In general, a more targeted approach may reduce the chance of unintended macroeconomic effects of broad-based monetary, fiscal, or exchange rate policies—or even capital controls. To the extent that the banking sector is funding speculative investments in stock and real estate markets, exposures can be closely monitored or reduced through selective imposition of higher reserve requirements, higher downpayment requirements for real estate purchases, or higher reserve margins for equity investments. However, effective financial market regulation and supervision requires well-trained professionals with independence, a professional code of standards, and the ability to engage sophisticated market players. Therefore, Korea, which has experienced current surges in capital inflows, should expand its risk management policies on credit expansion into the equity and real estate market.

Download this Discussion Paper [ PDF 443.4KB| 35 pages ].

Post a Comment

We welcome your feedback on this publication. Post a comment. ADBI is not obliged to acknowledge or publish comments and may abridge or edit them before web posting.

Comment(s)

There are [0] comment(s) for this entry. Post a comment.