Trends of Capital Flows in Korea

This section presents the stylized facts of capital flows in Korea especially since the currency crisis. We identify the main factors behind the current surges in capital flows in Korea. The capital flows in Korea, like in other emerging market economies, have many important policy implications. The theoretical literature suggests the presence of many direct and indirect channels through which financial market liberalization and opening could help improve efficiency allocation, assimilate new foreign technology–mostly through FDI inflows–and stimulate growth in emerging market economies. In theory, integration with international financial markets enhances growth potential and eases the burden of adjustment to external shocks in emerging economies. An increase in capital mobility between rich and poor countries, for instance, allows a high rate of investment and hence a high rate of growth in capital-poor emerging market economies while offering a higher rate of return on capital to capital-rich advanced countries. In a financially open economy, domestic residents can diversify their asset portfolios to include those issued by foreign firms and financial institutions in addition to domestic ones. The increased ability to diversify risk allows firms in emerging market economies to reduce the cost of capital adjusted for risk and hence invest more than otherwise.

When it becomes integrated into the international capital market, an emerging market economy can relieve its external deficit as well as unemployment that reflects its internal imbalance. For example, an adverse supply shock to a given industry of the economy may require shifts in labor and capital to other industries. After all adjustments have been made domestically, including a fall in factor prices, some factors of production are likely to remain unemployed when the capital account is closed. However, deregulated and open domestic capital markets in theory can facilitate the migration of the unemployed capital to other countries, thereby mitigating the burden of adjustment through changes in factor prices and employment. In other words, real capital mobility can be a partial substitute for price-wage flexibility.

Financial capital can move freely and quickly across borders in the absence of capital controls, but installed capital such as plants and equipment is not mobile, at least in the short run. Firms in a country that sustains an adverse demand or supply shock may be able to close plants quickly, but it may take months or years to move production facilities to other countries, or to create facilities abroad.² As a result, in the short-run, real capital mobility is low and only in the long run can it ease difficulties of adjustment to demand and supply shocks. In the absence of price and wage flexibility, an adverse supply shock such as an oil price increase may thus result in a deficit on the current account in addition to both an increase in unemployment and a decrease in factor prices. Emerging market economies with easy access to both regional and global capital markets will find it easier and less costly to borrow in order to finance their current account deficits. External borrowing can make the real adjustment unnecessary if the deficit is transitory and hence reversible.³ Even when the deficit is permanent, the borrowing allows the cost of the adjustment of consumption spending to be spread over time.

Through the risk diversification of portfolio investments, an emerging market economy can share some of the loss resulting from an adverse supply shock with other countries to the extent that it holds claims on their outputs. This means that, together with the access to international capital markets, this diversification of country-specific risks allows the smoothing out of fluctuations in consumption that the shock would cause. The amount of the loss that can be shared will increase if the country holds a diversified portfolio of bonds and equities from countries with different structural characteristics and with lower business cycle correlations of macroeconomic variables.

There are other potential advantages associated with financial market integration. As pointed out by Prasad, Rogoff, Wei, and Kose (2003), financial market integration promotes specialization in production, improves efficiency in the financial intermediation industry, encourages better economic policies, and has the effect of signaling the commitment to liberalization. How significant are these gains in reality? Most empirical studies on financial market integration do not find such positive effects. Although their rates of return on capital are in general higher than those of advanced countries, many East Asian countries have long been net capital exporters, especially so since the 1997 crisis. Prasad et al. also indicate that financial integration is neither a necessary nor a sufficient condition for sustaining a high growth rate unless capital receiving countries have developed the institutional capacity to achieve efficient allocation of foreign capital.

Nor do they find any evidence that emerging economies can expect better consumption smoothing through integration into global financial markets. In fact, volatility of consumption relative to output increased in the emerging market economies during the 1990s–the heyday of financial integration. Prasad et al. argue that this volatility will decrease once the emerging market economies develop their capacity to absorb foreign capital. However, it will take a long time for many emerging market economies to improve human capital, governance, and the efficiency and stability of the financial system, which determine their absorptive capacity. By the time they have developed the capacity, they may not require any capital inflows from advanced economies.

Recently, Korea like other emerging market economies has experienced huge capital inflows. The profit-seeking activities and diversification of risks by domestic and multinational financial institutions were the main contributors to increased cross-border capital flows. On the other hand, with the turn to the 1990s, capital inflows on a global scale started to take multiple forms, as investors from advanced economies diversified their assets internationally. Cross-border capital flows in general grew rapidly from the 1980s, because institutional investors began to show a high tendency to diversify their international portfolios in order to lower risks. In addition, the development of information and communication technology enabled global investment and broadened opportunities for investors to manage risks though investment in diversified financial assets across countries. In line with this, the changes in the form of capital flows in emerging market economies have been induced to both push effect and pull effect. In other words, with lower returns on domestic capitals due to sluggish economic growth in the advanced economies, investors' demand for investment in emerging market portfolio began to soar. At the same time, major emerging market economies relaxed their regulatory measures on cross-border capital flows.

2-1 Patterns of Capital Flows

Korea has experienced different types of capital flows during the last three decades. The total gross capital flows increased from $1.2 billion in 1980 to $49.1 billion in 2006. The share of total gross capital flows to GDP also increased from 2.0 percent in 1980 to 5.5 percent in 2006 (see Figure 1 [ PDF 54.1KB | 1 pages ]). In terms of type of gross capital flows, bank loans were the dominant form in Korea. Since the beginning of the1980s, bank loans have made up most of the capital flows in Korea. However, in the second half of the 1980s, FDI flows increased beginning with the government's liberalization of FDI inflows, and became a primary source until the currency crisis in 1997. Although equity investment caught up with FDI investment after the crisis, FDI is expected to continue to remain an important source of capital flows in Korea. As a result, the equity-related capital flows now dominate capital flows in Korea. In 2003, the equity gross flows made up 50 percent of the total gross flows in Korea.

Unlike equity, debt financing is not an important component of capital inflows in Korea. In particular, the rudimentary development of the bond market has been cited as one of the main reasons for the Asian crisis. Ideas for promoting regional bond markets have been proposed and are under close examination.

Gross debt inflows have increased recently, from $6.7 billion in 2001 to $28.9 billion in 2006. The increase is mainly due to purchases by domestic financial institutions of domestic bonds from overseas. This is regarded as non-resident purchases of domestic bonds since transactions by domestic financial institutions located outside of the territory are recorded as non-resident. At the same time, domestic financial institutions have invested heavily into foreign long-term bonds since 2001, and this has caused huge portfolio outflows in term of long-term bonds. This is why bond flows recently seem to have become a dominant form of capital flows in Korea. Bank financing has had the most volatility in Korea. It has plummeted twice, in 1986 and after the 1997 currency crisis. Since then, it has accounted for only a negligible amount of capital flows in Korea.

The total amount of capital inflows into Korea has increased almost 11 times from $1.2 billion in 1980 to $14.6 billion in 2006. During this period, Korea has experienced different types of capital flows. In the early 1980s, bank loans were the most important capital inflows along with transfer payments. Since most other types of capital inflows were prohibited, the Korean government encouraged domestic banks to borrow from abroad in order to fill the current account deficit. Foreign investors were only allowed to participate in the equity market through investment trust funds such as the Korea Fund, which had been listed on the New York Stock exchange since 1981. In 1990, foreign equity investment in the Korean stock market was partially allowed with limitations on the share purchased by foreign investors, and since 1998 there have been no limitations on holdings of domestic equity by foreign investors. Following reflection on these liberalization measures, the equity inflows were increasing before the crisis. However, in 1997 the inflows declined significantly due to the crisis, but soon recovered and have increased steadily since then. Equity has been seen as a candidate for resolving the currency crisis, and the government removed most barriers to investment in the equity markets in early 1998. As a result, equity financing decreased rapidly in 1999, but its momentum was reversed in 2000 due to the global burst of the IT bubble. In 2003, foreign investment in the domestic equity market reached a record high of US$14.4 billion, but since 2005 the equity inflows have declined significantly due to the global rebalancing from the sub-prime mortgage crisis. FDI flows have shown a relatively steady increasing pattern. Foreign banks have been extremely cautious in their cross-border lending in Korea. Thus the inflows of bank loan have shown a negative value, implying that foreign banks have repatriated their loans since the crisis. In the post-crisis period, bank loan inflows have been negative except for the year 2006.

Figure 2: Patterns of Capital Inflows in Korea [ PDF 32.3KB | 1 pages ]

Capital outflows have increased rapidly in recent years and have reached an unprecedented level. Gross capital outflows reached $34.3 billion in 2006, increasing nearly 5 times over the last 10 years. FDI investments have been the major components of outflows until year the 2000. Korea's direct investment abroad has increased at a steady pace. Since the late 1990s FDI investment to China has rapidly increased. However since 2001, portfolio investments have made up more than 60 percent of capital outflows in Korea. This reflects the liberalization of restrictions on resident investment abroad. It is surprising that equity investment abroad increased so rapidly in a single year, from $3.6 billion in 2005 to $15.2 billion in 2006. This trend is expected to continue for some time since overseas fund investments are increasing due to risk diversification and profit-seeking behavior by individual and institutional investors in Korea.

Figure 3: Patterns of Capital Outflows in Korea [ PDF 76.9KB | 1 pages ]

Since capital outflows have been increasing from 2004, net capital inflows into the Korean economy have actually decreased over the last two years. In 2006 in particular, net capital inflows recorded -$19.7 billion. A fall in net portfolio inflows was the main driver for the rapid decline in net capital inflows. The fall in net portfolio inflows has been driven, more recently, by a large increase in Korea's outward investment in equity. The equity investment abroad reached an unprecedented level of $23.6 billion in 2006. On the other hand, the net capital inflow scaled by GDP maintained a stable level in terms of historical average. The ratio of net capital inflows to GDP has been 1.4 percent since the crisis.

Figure 4: Patterns of Net Capital Inflows in Korea [ PDF 76.9KB | 1 pages ]

2-2 Brief Summary of Capital Account Liberalization in Korea

Capital flows in Korea are to a large extent related to the openness of capital markets, as in other emerging market economies. Since the 1980s, the government has continued to open capital markets to foreign investors, as well as to allow domestic agents to invest abroad. Depending on the degree of openness of capital inflows and outflows, the patterns of capital flows have varied as we have seen in the previous sub-section. However, since the 1997 crisis, most restrictions in capital flows have been liberalized. As a result, capital flows have been determined by the market principle in and out of the Korean economy.

Throughout the 1980s, the policy of the Korean government on capital flows depended on the current account balance. Under the pegged exchange regime, the capital inflows were used to accommodate the overall balance of payments. Therefore, the overall balance of payments fluctuated around a net zero balance, and the current account and capital account moved in opposite directions (Kim, Kim and Wang, 2004). In 1988, the Korean government formally accepted the obligations of Article VIII, Section 2-4 of the IMF's Articles of Agreement and abolished its remaining restrictions on payments and transfers for current account transactions.

With the intention to join the OECD, Korea accelerated its capital account opening in the early 1990s. In 1992, foreign investors were given permission to purchase Korean stocks up to three percent of the outstanding shares of each company per individual, but no more than ten percent of a company in total. In June 1993, the Korean government put forth a blueprint for the liberalization and opening of the financial sector, aiming at substantial progress in the financial market deregulation. The plan envisaged further easing requirements for foreign exchange transactions, widening the daily won-dollar trading margins, expanding limits on foreign investments in the stock market and permitting long-term commercial loans (see details in Park, 1995). Further capital account liberalization became inevitable when Korea joined the OECD in 1996. However, the Korean government continued to maintain many reservations to the code of liberalization of capital movements and current invisible operations. In the membership negotiations, Korea was reluctant to liberalize its capital account out of concern that foreign capital inflows would increase dramatically due to the interest rate differentials between home and abroad. The government had thus planned to delay the capital account liberalization until the interest rates converged significantly.

Thailand's sudden decision to float the baht on 2 July 1997 also caused the Korean won to depreciate rapidly. Following futile attempts to defend the currency, the Korean government widened the won's trading band from 2.25 percent to ten percent on 19 November, and finally abolished the band, allowing the won to float, on 16 December. With the floating exchange rate system in place, the Korean government also accelerated its ongoing capital account liberalization plan. Under the IMF program, the Korean government agreed to undertake bold liberalization measures. The capital markets, including the short-term money markets as well as the real estate market, which had once been off-limits and considered non-negotiable, were all completely opened to foreigners in 1998.

Most of the important liberalization measures were adopted during the free floating exchange rate regime period under the IMF program. In December 1997, the government raised the ceiling on the overall foreign ownership of stocks from 26 percent to 50 percent. The individual ceiling was raised from seven percent to 50 percent. These ceilings were lifted completely on 25 May 1998. All regulations on foreign purchases of debt securities were eliminated in December 1997. As of that date, all domestic enterprises, regardless of size, were allowed to borrow without limit from overseas, as long as the maturity did not exceed one year. All the short-term money market instruments, such as commercial papers and trade bills, were also fully liberalized on 25 May 1998.

The liberalization of restrictions on capital movements was accompanied by a relaxation of rules governing the use of foreign exchange. The Foreign Exchange Transactions Law was newly drawn up as a substitute for the Foreign Exchange Management Law, and went into effect in April 1999. In particular, it replaced the positive list system with a negative list system, which allowed all capital account transactions except those expressly forbidden by law. While foreign exchange dealings in the past had to be based on bona fide real demand, speculative forward transactions were now permitted. The new system was set to be implemented in two stages, in April 1999 and at the end of 2000, in order to allow sufficient time to improve prudential, regulatory and accounting standards before full liberalization. The first stage of the new system eliminated the one-year limit on commercial loans while liberalizing various short-term capital transactions by corporations and financial institutions. Moreover, foreign exchange dealing was opened to all eligible financial institutions. Further, in 2006, the Korean government announced its decision to advance the implementation schedule of the ongoing foreign exchange liberalization, which will be completed in 2009.

Even though these relative rapid liberalization measures have been implemented since the crisis, there remain a couple of policies which might impede the capital flows in Korea.⁴ All direct restrictions on original transactions of current and capital transactions have been removed with the exception of the ceiling of US$3 million on overseas real estate investments. However, procedural restrictions on original transactions still exist, for example, some of capital transactions still must be reported to the Ministry of Finance and Economy and the Bank of Korea. As for foreign exchange transactions, or the settlement of original transactions, only overseas transactions using abnormal means of transfer that bypass banks, such as exchange manipulation, are required to be reported to the Bank of Korea in order to restrict unlawful transactions.

2-3 Stylized Facts on Capital Flows in Korea

In terms of the type of capital inflows in Korea, bank loans were the most important capital inflows in the 1980s. Debt financing increased significantly in the late 1980s. On the other hand, beginning in the early 1990s, equity inflows increased significantly and became a major source of capital flows. FDI, compared to other investment flows, is known to be a stable source of capital. It has been steadily increasing since the early 1990s. It is interesting to note that bank financing has shown to have the most volatile flows in Korea. On the contrary, since the crisis, equity has been the most dominant type of capital flows. In the following section, we will describe major stylized facts on capital flows in the Korean economy.

2-3-1 From Capital Importer to Capital Exporter

Traditionally, Korea has been a capital importing country. Foreign capital has financed domestic investment, increased the general productivity of the economy, and contributed to long-term economic growth. As a result of the high economic growth and increasing domestic investment, Korea experienced a current account deficit before the crisis. With the exception of the period from 1986 to 1989, the current account deficit recorded an average of 2.5 percent of the GDP before the crisis. However, the rapid devaluation of the won/dollar exchange rate, fall in domestic investment and imports, and increase in exports, have resulted in a current account surplus since the crisis.

Figure 5: Current Account in Korea [ PDF 25.7KB | 1 pages ]

Moreover, as we saw in the discussion of net capital inflow trends in the previous section, Korea has recently become a capital exporter due to its more recent increase in gross capital outflows, especially equity outflows. Owing to the capital outflows and current account surpluses, Korea turned from a capital importer into a capital exporter in 2006. The trend is expected to continue during the next few years. This implies that the foreign capital inflows are no longer functioning to provide capital for domestic investment.

2-3-2 Exporting Risky Assets and Importing Safe Assets

Portfolio investment, including into bonds and stocks, has been increasing in most emerging economies since the 1990s. Portfolio transactions were almost negligible in most emerging market economies in the 1980s, but in the following decade, portfolio investment inflows such as bonds (especially for Latin American economies) and stocks (especially for Asian economies) began to expand in proportion to the total capital inflow in emerging market economies. Normally it is difficult to expect active cross-border portfolio investment in a country without well-developed macroeconomic policy instruments or with a weak financial system. Nevertheless, the fundamental reason for the extensive spread of portfolio investment across regions is the international diversification of assets by advanced economies. Cross-border portfolio investment in emerging market economies is rising, as the demand for bonds and stocks of emerging markets by institutional investors from the United States, Japan, and Europe is increasing. Bottom-low interest rates and the slowdown of economic growth in the major advanced economies are other significant reasons. At the same time, emerging market economies loosened their regulatory measures on domestic portfolio investment through capital liberalization, leading to the expansion of international portfolio investment.

The patterns of capital flows show that Korea has exported risky assets to developed economies and imported safe ones from advanced countries. Even though capital outflows increased in recent years, Korea's investors have revealed a strong preference for wise assets. The yearly average amount of cross-border bond purchases by domestic investors has been $5.5 billion from 2001 to 2005. On the other hand, the yearly average amount of cross-border equity purchases by domestic investors has been $2.2 billion during the same period. This reveals that domestic investors have a strong preference for safe assets due to their risk-averse behavior, as they consider equities to be riskier assets than bonds.

Korea's portfolio inflows, however, show that foreign portfolio inflows are heavily concentrated into equity flows. With the exception of 2005 and 2006, domestic equities have been the dominant portfolio investments by foreign investors since the crisis. Furthermore, comparing the foreign holdings of domestic equities and bonds, the share of foreign equity holdings to the total market capitalization in Korea was very high, at 35.2 % in 2006, while the share of foreign bond holdings was merely 0.59 percent in the same year.

Figure 6: Foreign Equity Holdings [ PDF 42.2KB | 1 pages ]

Figure 7: Foreign Bond Holdings [ PDF 42.2KB | 1 pages ]

2-3-3 FDI as a Stable and Primary Source of Capital

FDI inflows in Korea have proven to be a stable and steady source of capital inflows. Unlike other types of capital inflows, FDI inflows have increased steadily from the early 1980s. FDI began to play a dominant role in total capital flows in the mid 1990s. The government also promoted increased FDI inflows, providing special incentives to foreign firms to set up companies. This trend was caused by the following reasons: (1) they give positive externalities to the recipient country, such as transfers of technology and management skills and (2) it is costly for FDI to reverse direction, thus having less volatility; FDI relies on longterm profits of investor companies, as it has little sensitivity to international interest rates.

The coefficient of variation of FDI flows in Korea is lower than that of other capital flows. The coefficient of variation of FDI is 0.81, while it is 1.13 for equity, 1.19 for bank loans and 0.90 for debt. This confirms the view that FDI flows are considered cold money which is generated by the long-term considerations of foreign investors. In contrast, portfolio investments are seen as unstable hot money, which is triggered by short-term consideration of the foreign investors.

Table 1: Coefficients of Variation of Capital Flows in Asia [ PDF 19.2KB | 1 pages ]

However, the argument for the irreversibility of FDI is worth examining more carefully. Albuquerque (2002) suggests that withdrawals of FDI do not necessary have to include the liquidation of physical capital, and in fact foreign investors in FDI have many ways to withdraw funds that are invested as direct investment, such as by selling shares. Related to this, the liquidity condition of the capital market is crucial in determining the lower volatility of FDI flows in a country. Lipsey (1999) shows that the volatility of net FDI flows is smaller in developing than in developed countries, and the differences in volatilities between net FDI flows and other types of net inflows are smaller in developed economies.

Figure 8: FDI Inflows [ PDF 19.2KB | 1 pages ]

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