KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Research Monograph KOR Foreign Exchange Policy in Response to Changes in Macroeconomy and Financial Markets

This study analyzes the relationship between cross-border capital flows and the foreign exchange market in Korea. It aims to propose revisions to the Foreign Exchange Transaction Act to facilitate international transactions and maintain external financial stability in light of changing macroeconomic and financial market environments.

The foreign exchange system is shaped by historical contexts, typically introduced to minimize the negative impact of currency fluctuations during events such as economic recessions or wars. However, as economies develop and financial markets grow, there is an increasing demand for the relaxation of regulatory measures on foreign exchange transactions.

As an open economy highly dependent on external trade, Korea encounters considerable risks to its economic stability from rapid fluctuations in exchange rates. Therefore, understanding the relationship among cross-border capital flows, interest rates, and exchange rates is crucial in crafting an effective foreign exchange system. Despite the projected increase in fiscal spending to address the aging population and enhance the quality of life, Korea's overall savings are expected to grow for the time being. With the domestic potential growth rate declining, it seems that the demand for private external financial investments will persist, indicating an expected increase in cross-border capital movements. The growth in private external financial investments presents an opportunity to ease regulations in the foreign exchange market, as the private sector can serve as an automatic stabilizer against exchange rate volatility by actively participating in the foreign exchange market and restoring normal rates.

Chapter 2 examines the impact of increasing domestic and international capital flows on Korea's financial markets. Analyzing the effects of foreign capital inflows using the Flows Implied by Rebalancing (FIR) index (Pandolfi & Williams, 2019), this chapter indicates that global passive fund inflows are associated with significant increases in bond prices (lower interest rates) and a strengthening of the Korean won (weaker exchange rate). These effects are more pronounced for non-reserve currency emerging market countries like Korea. Furthermore, the study investigates the impact of domestic funds' overseas investments on the foreign exchange market. It uses a synthetic control method to assess the effects of the 2017 policy that recognizes asset duration irrespective of insurance companies’ hedging practices. The findings show that an increase in domestic securities investments abroad leads to a decrease in the real effective exchange rate, resulting in a depreciation of the Korean won. However, there is no evidence that excessive demand in the foreign exchange market rises as swap rates increase, suggesting Korea’s foreign exchange market has gained stability compared to the past. An examination of the correlation between the won-dollar exchange rate volatility and the amount of net foreign assets reveals that more recently, as net foreign assets increase and the ratio of won-denominated liabilities rises, the amplitude of the net foreign asset increase due to non-trading factors tends to rise when the won depreciates, indicating the operation of an automatic stabilizer.

Chapter 3 puts forth the direction and key policy recommendations for the revision of the Foreign Exchange Transaction Act. The focus is on enhancing the efficiency of foreign exchange transactions while pursuing external stability. It suggests recognizing the Foreign Exchange Transaction Act more as a trading law than a business law, aiming to reduce overlaps with individual financial laws arising from its business law characteristics.

More specifically, Chapter 3 explores the history of Korea’s foreign exchange management policies and analyzes their characteristics and problems. Initially designed to curb the outflow of foreign exchange, these policies have since transformed to liberalize foreign exchange transactions across both current and capital accounts. However, the foreign exchange authority has maintained a conservative stance, prioritizing external soundness. Notably, the Foreign Exchange Transaction Act is recognized as a business law, maintaining a bank-centric approach while regulating the foreign exchange operations of non-banking financial institutions. Furthermore, the Act adopts a listing and delegation legislative approach. As a result, the current law is not only vulnerable to changes in the external environment but also faces issues of low legal systematicity, leading to high compliance costs.

Currently, most developed nations operate without legal restrictions on foreign exchange transactions. Countries that initially introduced regulations as a response to economic crises or wars have either eliminated or considerably eased these regulations to improve national competitiveness and foster the growth of their financial industry. Japan, whose foreign exchange system has historically resembled Korea’s, opened up foreign exchange operations to non-banking financial institutions and even non-financial companies as part of its financial big bang in 1998. However, Japan has retained a regulatory role in terms of information collection and monitoring for foreign exchange transactions. It continues to inspect and supervise foreign exchange operations of individual financial institutions under the applicable financial industry laws or laws governing financial product transactions.

This study proposes revisions to Korea’s Foreign Exchange Transaction Act based on international case studies. First, the Foreign Exchange Transaction Act, presently skewed towards business law characteristics, should shift its focus to underscore its role as a trading law rather than a business law. To invigorate foreign exchange transactions, the Korean government should move away from classifying foreign exchange operations as regulatory subjects and instead strengthen the monitoring and reporting systems for transactions. It is advisable to delegate regulation of foreign exchange operations to financial authorities under individual financial industry laws, with the Foreign Exchange Transaction Act stepping in only where foreign exchange operations are not covered under the relevant financial industry laws.

Second, this study recommends transitioning the regulatory approach for foreign exchange transactions under the Foreign Exchange Transaction Act from institutional to functional regulation. Functional regulation involves categorizing operations by their function and applying consistent regulations to identical activities, laying the groundwork for adapting to future changes, such as the digital transformation of finances.

Third, in response to the relaxation of foreign exchange regulations, the study suggests reinforcing liquidity and soundness for non-bank financial institutions. This compensatory measure addresses concerns associated with the shift toward functional regulation, which might essentially eliminate bank-centric practices, posing potential risks to financial stability due to the risk-taking practices of non-banking financial institutions. Specific measures include applying foreign exchange liquidity coverage ratio (LCR) requirements for financial investment firms, enhancing the effectiveness of Net Operation Capital Ratio (NCR) regulations, strengthening the responsibilities of boards and CEOs as licensing conditions for foreign exchange operations, and ensuring continuous supervision and inspections post-authorization. This approach mitigates concerns about functional regulations compromising external soundness by adopting a ‘same taskssame riskssame regulations’ rule at the financial regulatory and supervisory level to respond to systemic risks.

Finally, the study proposes imposing prompt corrective action measures on financial institutions handling foreign exchange transactions to enhance the effectiveness of safeguards before emergencies arise. Corresponding to the extent of regulation relaxation on foreign exchange operations, the Korean government strengthens the liquidity and soundness of financial institutions engaged in foreign exchange operations by enforcing prompt corrective action when various regulatory ratios are exceeded. Such measures not only minimize the broader systemic impact in case of early-stage insolvency but also incentivize companies to uphold sound management practices.

While Korea's foreign exchange system has evolved to reflect changes over time, the pace of these changes has been notably slow. While Korea actively engages with the international community, its efforts to liberalize foreign exchange transactions are constrained as a non-key currency nation. Nevertheless, the need for reform in the current conservative foreign exchange system persists for the sake of economic and capital market development.

Despite Korea’s orientation toward an open economy, its view on openness has traditionally centered around trade. From the early stages of economic development, exports have served as the primary engine of Korea’s economic growth, leading to minimal regulations on current account transactions. Consequently, foreign exchange transactions related to current account activities have been freely permitted. On the contrary, foreign exchange transactions for capital account activities have faced stringent regulations. While strict control over foreign exchange transactions might initially boost financial stability, it could also lower overall economic efficiency and potentially decelerate economic growth. Furthermore, ensuring financial stability requires collaborative efforts and coordinated actions among monetary, fiscal, financial, and financial supervisory authorities to enhance the stability of the financial system.

In conclusion, the study advocates for a significant easing of the regulations on foreign exchange transactions in Korea, recommending adjustments to match the current economic conditions and national competitiveness strategy. Korea’s financial institutions are positioned to lead the development of the financial system, especially as global portfolio diversification emerges as an economically efficient choice. This shift is happening against a backdrop of declining potential growth rates and rising demand for both domestic capital investments abroad and foreign capital investments within Korea. Therefore, it is imperative for the Korean government to comprehensively reassess restrictive regulations that hinder the global expansion of financial institutions, with the restrictions imposed by the Foreign Exchange Transaction Act as a prime example of such regulation in need of thorough reevaluation.

Summary

Policy Study KOR Inflation Expectations Through the Lens of the Slack in the Real Estate Asset Market

This study examines inflation expectations implied in the real estate asset market. Land is an asset that accounts for more than half of South Korea's national wealth and, like labor, is an essential input factor despite its inelastic supply. Based on this idea, we examine whether a similar regularity as the Phillips curve observed in the labor market is also observed in the real estate asset market. The main results are as follows. First, an increase in the relative price of land can be a pass-through, transferring inflationary pressure over the years. Second, comparing the existing expected inflation indices, an expected inflation rate extracted from the real estate asset market can provide additional information. Third, theoretical analysis shows that the relative price of land and expected inflation can be positively correlated in general equilibrium.

Summary

KDI FOCUS Galapagos Syndrome in South Korea’s Real Estate PF, and the Need for Fundamental Structural Reform

Over the past several decades, real estate project financing (PF) has repeatedly triggered economic disturbances in Korea, with no fundamental remedies in sight until now. Project sponsors are at the heart of this issue, investing minimal equity while heavily relying on guarantees from third parties, such as construction firms, to push forward development projects entirely on debt. This financing structure is unheard of in major advanced countries. Korea needs to reform its unique PF structure by augmenting capital and reducing dependence on guarantees.

- Over several decades, real estate project financing (PF) has repeatedly destabilized the Korean economy, but fundamental improvements have not been made.

- The root cause of PF problems lies in the unique financing practice of relying almost entirely on debt, where developers invest very little equity and depend heavily on third-party guarantees.

- In Korea, the equity ratio of developers is around 3%, while in major advanced countries, it exceeds 30%.

- In major countries, land is secured with equity capital, and only construction costs are financed through loans. This approach prevents the issue of refinancing bridge loans into main PF loans, which is typical in Korea.

- In major countries, it is rare for third parties, rather than developers, to guarantee PF loans, unlike in Korea.

- The low-equity and highguarantee structure leads to more developers becoming smaller in scale and underfunded.

- The low-equity and highguarantee structure leads to poorer assessments of project feasibility, no-questions-asked investments, and increased macroeconomic volatility.

- The low-equity and highguarantee structure shifts all risks to the national economy, not developers.

- Since advanced countries base loan issuance on project feasibility and financial structure per PF principles, capital augmentation is a prerequisite for developers to obtain loans.

- However, when Korea introduced PF, the market consisted of small developers and large construction firms. This disparity led to a low-equity, high-guarantee structure, which was reinforced by the pre-sale system.

- The prudent direction would be to raise the equity ratio to the level of advanced economies and abolish third-party guarantees. To that end, Korea should introduce regulations on capital augmentation.

- While regulations to increase capital may constrain the quantity of housing supply, they are expected to improve its stability.

- Even in environments unfavorable for scaling up, some developers have started small and grown into conglomerates, while others are affiliates of large corporations.

- The pool of potential equity investors is not limited.

- Because REITs socialize development profits and are already subject to equity ratio regulations, it is desirable to revitalize their equity investments or foster their direct participation as project sponsors.

- During the transition, it is necessary to implement support policies that encourage capital increases.

- The acute lack of data on real estate PF makes it difficult to even stay current, which in turn only allows temporary measures during crises and hinders regular monitoring or early crisis detection.

- A database system should be set up to collect official statistics on financial and business information by project and company.

Summary

Research Monograph KOR Managing Changes in Korea’sExternal Economic Conditionsamid the US-China Rivalry

This study analyzes tensions between the US and China, employing different viewpoints of international politics, supply chain disruptions, and ripple effects on the real economy and financial market, and presents the following implications. Firstly, the US strategic approach to China shows that, unlike the previous Trump administration, the Biden administration maintains tensions and competition but stays away from direct conflict or confrontation. In response, South Korea should broaden its relations with the US to a more comprehensive diplomatic and economic alliance. At the same time, its strategic communication channel with China should remain open while strengthening its global strategic networks with other major countries. In doing so, South Korea must secure its position as a middle-power nation that can coexist among the great powers. Secondly, supply chain disruptions triggered by the US-China rivalry can be regarded as a geopolitical risk in global supply chains since the disruptions come from trade sanctions and foreign investment restrictions they are using against one another. Accordingly, South Korea needs to set up a risk management framework which includes an early warning system to enable preemptive responses based on risk measurement and evaluation. Thirdly, as the global supply chain shock caused by the conflict between the US and China is persistent and long-lasting, South Korean firms may experience greater shocks than during the COVID-19 pandemic. What would help counter this shock is to lay down the necessary infrastructures to upgrade its supply chains that can support the diversification of supply chains and networks of domestic firms and establish a smart logistics system. Lastly, financial sanctions against China by the US have the potential to significantly decrease foreign capital flows in the Chinese market, escalating capital outflow risks. Hence, it would be desirable for South Korea to monitor its linkages with Chinese financial institutions and to take appropriate preparatory actions to avoid the risk of economic sanctions targeting China by forming a cooperative relationship with the sanctioning authorities in the US.

Summary

Research Monograph KOR A Decade after the Global Financial Crisis and a New Growth Agenda for the Korean Economy

1. Shift in the Economic Policy Paradigm

Most notable among the changes in major economies in the wake of the 2008 global financial crisis is the shift in the economic policy paradigm in regards to the expansion of the government's role in the market. Consequently, growth agendas are seeking to enhance growth potential and a policy combination that could resolve structural problems to improve growth sustainability.

In Korea, although have been studies that linked the decline in the growth rate to problems in the social structure such as income inequality, the majority were unable to go beyond the trade-off between growth and distribution. After the global financial crisis, however, debates have grown over the fact that actively responding to social problems can contribute to sustainable growth. There is growing recognition that growth and distribution are no longer a target of contradicting policies and can be pursued in a complementary manner.

Thus, even if growth policies can satisfy the demands from an era of a paradigm shift to a universally strengthened policy, and presents the explicit goal of actively responding to concerns that the economy will be stuck with slow growth, the validity and effectiveness of the policies need to be constantly checked and supplemented. This study intends to analyze the post-crisis progress made on addressing Korea’s socioeconomic issues and to provide a basis to explore whether social structural phenomena, now being the target of policy correction due to their role in current problems, will be actually and empirically identifiable beyond some logic. This study analyzed the structural changes in major sectors that are considered as an important premise in planning and executing policies for sustainable growth but require a more thorough review. It also aims to ascertain how these changes are related to the key growth factors such as productivity.

2. Analysis of the Factors of the Recent Growth in the KoreanEconomy

This study first looks into slowing economic growth, the most obvious macroeconomic change faced by Korea since the global financial crisis. In particular, by analyzing the changes in growth factors using the growth accounting method, this study rechecked whether the fall in the growth rate was due to cyclical factors or was driven more by long-term structural characteristics.

According to the authors, the decline in economic growth in 2011-2017 can be explained by the drop in the contribution of physical capital and total factor productivity (TFP). Based on the finding that the decreased growth in TFP led to the reduced growth in marginal capital productivity and thus, diminished the contribution of material capital, the authors consider it too early to conclude that investment in physical capital has been stagnant since the global financial crisis. In addition, considering that Korea’s growth capacity is slowing on rapidly aging demographics, the future will be dependent on how well the productivity growth can buffer the pace of slowing growth. Even with continuous efforts to enhance productivity, Korea’s economic growth in the 2020s is expected to slow down to about an annual 2% on average. This result implies that the slowing growth of the Korean economy can be seen as a long-term structural phenomenon, and that a clearer understanding of the structural economic changes is needed when designing responsive policies.

3. Corporate Labor Share of Income and Market Dominance

This study found that contrary to domestic studies stating that labor share has continued to descend since the foreign exchange crisis in the late 1990s, large enterprises—subject to the external audit system—exhibited a rebound since the 2000s following a decline from the early 1990s. The study focuses on 'market changes' such as technological progress, growing trade represented by globalization, and the increase in monopoly profit as factors driving the change in the labor share of income. This point is where this study distinguishes itself from previous studies, concentrating on labor market flexibility, including rising non-regular workers, in the post-crisis period, and the ensuing relative sluggishness of labor and household income growth. In particular, this study found a close correlation between the markup—that represents the market concentration of Korean firms—and labor income share, and the fact that the markup has declined since the 2000s while labor income share has risen suggests that there have probably been positive welfare effects on the Korean economy.

This study reviews various adjustment measures and provides alternatives for measuring labor income share. Taking into account their problems, the author reexamined the trend of labor income share and analyzed the relationship between markup and labor income share—as a variable related to corporate decisions and market structural changes. In doing so. this study intends to suggest an important reference point in understanding the causes and backgrounds of social structural problems such as income inequality in our economy, and seeking solutions.

4. Causes of Increased Corporate Savings and the Ripple Effects onGrowth and the Distribution Structure

This analysis targets the problem of increased corporate savings. The mounting savings by corporations implies that firms are relatively indifferent about developing production capabilities for the future, indicating that the economy will slow as the growth of total factor productivity (TFP), including technology input and progress, decelerates. Some view this as a sign that the economy will face low growth as TFP growth—including capital input required for growth as well as technological progress—slows down. Others argue that rising cash holdings is the optimal choice for firms coping with increasing uncertainties, and most of the savings are used for the formation of fixed assets and hence, there is no need to view it only negatively.

Between these two opposing views, this study begins with checking the validity of the latter. In the Korean economy, the increase in corporate savings is usually due to a rise in fixed capital consumption and savings-investment gap. Particularly after the 2000s, firms may have chosen to increase their corporate savings to deal with the increase in fixed capital consumption resulting from technological changes. This could lead to a widening productivity gap between firms actively adapting to the technological changes and those that do not. This study found that corporate savings have a significant positive correlation with productivity growth―instead of the possibility that firms accumulating cash will exhibit inefficiency. These findings suggest that a policy curtailing corporate savings could undermine the efficiency of the market as it could distort the optimized corporate decision-making and reduce incentives to push for technological change.

5. Household Debt and Private Consumption

This study analyzes the macroeconomic risks inherent in rising household debt and draws on the implications for growth policy. The problem of mounting household debt has been recognized as the most characteristic risk factor for the Korean economy over the past several years. On the other hand, unlike most advanced economies who have expanded their debt to avoid a plunge in growth after the global financial crisis, Korea has put fiscal soundness before others in pursuit of growth at the expense of the financial soundness of the household sector.

This study can be of great importance for discussions on future growth policies as it examines the role of household debt in relation to sluggish private consumption after the crisis and draws on the implications of slow growth. It empirically showed that Korea’s household debt could amplify the instability and thus, weaken the growth of consumption, resulting in sluggish growth. Debt will have a bigger negative impact on consumption during the phase of aggravating recession, possibly leading to a longer slump and delayed recovery.

Based on these discussions, this study calls for a more active solution to the excessive household debt, as it will weigh heavily on the economy and entail enormous losses for social welfare. The author suggests that in normal situations, macroprudential policy should be strengthened by, for example limiting the proportion of overly indebted people in order to induce a soft landing. But, in a recessionary phase with shrinking domestic demand, monetary and fiscal policies should be managed through an expansionary stance. This is because macroprudential policy alone cannot restrain the downward pressure of aggregate demand from becoming prolonged particularly for heavily debted households. This study also stressed consistent efforts to rectify the financial weakness in the household sector as a full-fledged recovery of consumption cannot be expected unless financial soundness improves.

Summary

Policy Study KOR How Changes in Housing Finance Environment Affect Household Decisions and Market Equilibrium

This paper analyzes how changes in household debt policies and housing finance environment affect household borrowing decisions, housing prices, and welfare. I examine three types of housing finance environmental changes. First, when the government relaxes the loan-to-value (LTV) ratio regulation, housing price, rent price, and household debt increase simultaneously. An increase in the residence cost leads to a decrease in the economy-wide welfare. However, the proportion of households that support the relaxed LTV regulation is higher than non-supporters. Second, when the mortgage refinance is restricted, housing price, rent price, and household debt decrease. Though a decrease in residential expenses increases household welfare, the proportion of households that support such a change is less than the half of the entire population. Third, when the average household income decreases, housing demand, price, and rent price decrease. Since a decrease in household income reduces life time consumption, the economy-wide welfare decreases.

Summary

KDI FOCUS Household Debt Vulnerability and Directions for Risk Management

□ Korea’s households and banks seem relatively sound in terms of their loss-absorbing capacities. However, a number of worrying signs are present. Some of the negative indicators are the rising share of non-bank consumer loans; the large share of real estate out of household assets, borrowing in the form of short-term balloon payment loans, and the credit risk of low-income indebted households. Against this backdrop, a sound and effective risk management system needs to be designed based on a proper assessment of the current situation while differentiating normal from emergency measures and ex ante from ex post measures.

- The recent debate over household debt has included some mixed discussions in terms of risks to financial and social stability, micro-level conditions, and macro-level effects.

- The credit risk of households with loans from (systemically important) banks appears limited, while the risk of households with non-bank borrowings is relatively high.

- The majority of debt can be found in households whose repayment ability is relatively strong in terms of the level of income and (net) asset.

- The characteristics of asset and liability composition of household balance sheets have raised concerns about a liquidity mismatch between assets and liabilities and the risk of debt deflation.

- The large increase in household credit activity has led to a rise in the number of people in default, suggesting a need for a firm establishment of lending practices of financial institutions based on repayment abilities and an improvement in consumer debt-relief programs.

- Major tasks that lie ahead include a moderate degree of debt-deleveraging and mitigation of its downward pressure, stabilizing the loan structure, reconfiguring the consumer debt-relief programs, redefining the role of credit policies from the areas of social safety net, and improving labor market conditions and household income.

- Suitable responses should be chosen and implemented for different situations based on objective assessment and understanding on the given situations.

- Approaches for risk management should be designed in a way that differentiates between normal and emergency measures and between ex ante and ex post measures.

- Attention should be paid to the vulnerability of low-income borrowers though their credit risk may not pose systemic risks to the economy.

Summary

Policy Study KOR System Risks in the Banking Sector and Enhancement of Financial Regulation in Korea

During the global financial crisis, the failures of large and complex financial institutions resulted in financial disruption and government funded bail-outs with huge burden on tax-payers. Large financial institutions tended to pursue more risks at lower borrowing costs against the expectation of government bail-outs in case of failure. The incentive misalignment underlying the excessive risk-takings of the systemically important financial institutions (SIFIs) may need to be corrected to end the Too-Big-To-Fail (TBTF) problem. Against this backdrop, international communities, the G-20 nations in particular have pushed for structural financial reforms, including measures to end the TBTF problem. Financial regulation frameworks in Korea may need to be reformed in accordance with the international regulatory frameworks for effective systemic risk management. This paper assesses and identifies the systemic importance of domestic banks in Korea and discusses policy measures for the management of systemic risks in the banking sector.

The systemic importance of banks may need to be quantified in order to implement regulatory frameworks for systemic risks in the banking sector. Principles and guidelines about the measurement approaches recommended by the FSB and BCBS have been reviewed and discussed along with the recent practices taken by major countries. This study adopts an indicator-based approach and analyzes the public accounting information disclosed by domestic banks to measure and assess their systemic importance. The systemic importance of 17 domestic banks in Korea, categorized into three groups of commercial banks, special-purpose banks, and regional banks have been assessed in this study. The assessment shows that a few in groups of commercial banks and special-purpose banks appear to be systemically important by a large degree compared with other banks in the same groups while regional banks appear not much important systemically. The domestic banks whose systemic importance appear significant may need to be considered put in place under additional measures for systemic risk management while the special-purpose banks may be considered for how much of their purpose of establishment should be taken into account for adoption of systemic risk regulation.

Various measures may be considered to be introduced for systemic risk regulation. For example, measures such as higher loss absorbing capacities, strengthening resolution regimes, structural measures to restrict business models, and enhanced supervision may be considered. With respect to the higher loss absorbancy(HLA), the amount of the HLA for D-SIBs in Korea may not have to be held as much as those in major economies since the level of systemic importance of domestic banks in Korea appears low relative to that of D-SIBs in major economies. In order to implement the special resolution regimes, various kinds of resolution frameworks such as recovery and resolution plan(RRP), resolution assessment process(RAP), and gone-concern loss absorbing capacity(GLAC) may be considered for example. It should be noted that the purpose of strengthening the resolution regime is to end the TBTF problem by introducing a credible bail-in mechanism for orderly resolution without exposing taxpayers to losses while maintaining critical functions of financial firms in resolution. Among the resolution measures, the RRP and RAP could be introduced without much resistance from financial firms designated as D-SIBs. However, measures such as requiring GLAC for D-SIBs may be of a big burden and of controversy to stake-holders of those banks depending on the size and changes in their legal rights although GLAC may be at the heart of designing a credible bail-in mechanism. In addition, approaches such as structural measures or higher supervisory intensity could be considered depending on how the systemic importance of D-SIBs are recognized by financial authorities. It may be worth mentioning that the aforementioned measures should be chosen appropriately with rationales by taking the special conditions of domestic firms and markets into account because the approaches toward the D-SIB regulation are recommended to take principles-based ones according to guidances and practices mentioned above.

Summary

Policy Study KOR Causes of the Household Debt Build―up and Deleveraging Strategies: How Optimistic Belief Affects the Household Debt

This paper analyzes how households’ optimistic belief in their prospective income or macroeconomic conditions affects their borrowing decisions. Empirical analysis based on 2012-13 Survey of Household Finances and Living Conditions, released from Statistics Korea, shows that households with the expectation of increase in their income or house prices tend to take out larger amounts of loans than those who are not optimistic about future economic conditions. In addition, the fraction of households that hold any type of debt is higher among optimistic households than non-optimistic households. Furthermore, optimistic households are more likely to issue new debt than non-optimistic households are.

This paper then examines how optimistic belief about future income and interest rates influences household borrowing, consumption and default decisions. Even when actual income does not increase, households tend to loan and consume more on the expectation of income increase. However, if the economic environment does not turn out as expected, this could result in a sharp increase in the household default rate and a decrease in aggregate consumption.

These empirical and quantitative exercises give us following lessons. First, policy makers need to communicate with market participants in order to share objective situation about economic conditions. Second, government needs to take proactive measures, via tax or macroprudential policies, to prevent an abrupt increase in household debt.

Summary

Research Monograph KOR Financial Regulations on International Capital Flows and Exchange Rates

It has been widely known that global market openness and globalization have contributed significantly to the economic development of emerging markets, but now negative impacts have started to loom as a rapid cross-border capital flow after the global financial crisis has caused financial systems of emerging markets to become weaker. Accordingly, direct and indirect policy responses to international capital flows have been a key challenge for monetary and financial authorities of emerging markets.

Preceding studies understood that globalization has greatly helped emerging economies get easy access to required capitals for their economic growth and better quality of life, and that it is foreign financial institutions and global financial markets which played a critical role in this process of propelling capital flows. However, in the wake of the East Asian financial crisis in 1997 and the global financial crisis in 2008, emerging markets have revealed vulnerability in their financial systems, while it was found that the global financial system and international financial institutions also hold problems, thus resulting in requests for a new financial regulatory system on international capital flows.

This issue is also very important for Korea, with a high degree of openness, in the aspect of financial stability. With the onset of the global financial crisis in 2008, local banks experienced a halt in foreign capital inflow and the won depreciated sharply. Recognizing the risks involving cross-border capital flows, the Korean government responded with policies for macroeconomic prudence such as developing new regulations on international financial transactions. This study, based on empirical analysis of international financial transactions and case studies of emerging market economies, intends to suggest financial regulatory measures on the international capital flows and foreign exchange market in Korea, while particularly focusing on macroeconomic prudential policy, capital control and foreign exchange reserve; the chapter for macroeconomic prudential policy examines the need of macroeconomic prudential regulations and current status of its adoption in emerging market economies, followed by reviews on the impacts the same regulations had on Korea; the chapter on capital control includes feasible suggestions that could be more adoptable in reality than guidelines provided by IMF; and the chapter on foreign exchange reserve discusses theoretical models considering welfare effects and empirical effects of exchange rates of reserve assets.

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