KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Policy Study KOR Does Fiscal Instability Cause Financial Instability?

This study analyzes the impact of fiscal instability on the soundness of financial institutions. The IMF's long-term fiscal outlook (2021) forecasts Korea's public finances to weaken over the medium to long term. Deteriorating fiscal stability may undermine the soundness of the financial sector by way of the financing channels of government bonds and guarantees. Through an empirical analysis, this study finds that the higher the risk of sovereign default, as measured by credit default swap (CDS) premiums on government bonds, the higher the risk of bank default, as measured by bank bonds CDS premiums. Moreover, this study looks at other countries sharing similar fiscal and financial features as Korea―without reserve currencies, greater banking sector size relative to national revenue, and huge private sector credit that is rapidly expanding― and finds that for such countries, bank default risk is further amplified when sovereign default risk increases.

The analysis results may have two policy implications. Firstly, it is necessary to build up fiscal soundness, and this is an indispensable policy agenda item for the Korean economy to pursue over the longer term. Secondly, the banking sector needs to become less reliant on public finances and more self-sufficient. In case of a bank failure in contingencies, it is desirable to adopt a bail-in system that requires creditors to share the losses to rescue the defaulted financial institutions rather than bail-out, which provides relief at the expense of government revenue.

Summary

Policy Study KOR A Study on Financial Constraints of Korean Companies: Focusing on the Effectiveness of Policy Financing

This study analyzes financial constraints on business firms to enhance the effectiveness of policy financing. The importance of policy finance lies in its capacity to improve the efficiency of resource allocation in society overall by providing finances to firms unable to furnish capital from private financial markets due to a market failure. From a corporate viewpoint, market failures are business conditions faced with financial constraints, which mean difficulties obtaining necessary funds, despite good opportunities present in the market. Accordingly, it is expected that adequately identifying firms' financial constraints would boost the effectiveness of policy financing.

The study first constructed an index to measure the severity of corporate financial constraints based on business size and operation years. To verify the suitability of the index, the author examined whether firms less vulnerable to financial constraints would lower their debt ratio using the 2012 corporate tax cuts for medium-sized firms. Corporate tax reduction brings down corporate debt further as the supply curve of capital is elastic for firms without financial constraints. As a group of firms without such restrictions had a more significant drop in debt after the tax cut, the analysis confirmed that the new index successfully reflected the severity of financial constraints to a certain extent.

Furthermore, the study analyzed the Business Restart Funds operated by the Korea SMEs and Startups Agency to determine whether it is feasible to use financial constraints to better policy financing in its effectiveness. The analysis revealed that firms with severe financial constraints measured by the index ramped up investment after receiving policy funds, providing insights on generating more effective outcomes depending on the selection of beneficiary firms in executing policy financing.

Summary

Policy Study KOR Study on the Distribution of Income and Wealth and Household Debt

This study analyzes the relation between the rise in household debt and household characteristics such as income and assets using microdata on households. Based on the findings, implications are presented for the management of Korean households’ financial soundness and of the relevance of household debt to economic inequality.

The growth in household debt since the early 2000s is significantly associated with income and assets. On the one hand, in terms of income, bottom-income households have increased their debt relative to income by a big margin, possibly posing a threat to financial soundness. In addition, the rise in household debt is positively correlated with income growth, suggesting that the recent slowdown in debt growth is linked not only to the policies of tightening housing finance regulations, but also to the reduced income growth stemming from the macroeconomic slowdown. On the other hand, in terms of assets, households with larger assets exhibit a higher increase in their debt-to-income ratio compared to other households. The increase in household debt is positively correlated with the growth in real estate assets, which can be understood to mean that the increase in real estate assets is closely tied to the increase in household debt during the period in question. However, if the growth in real estate assets had been driven by temporary factors, it would be possible for the risk of debt default to increase as the real estate market would adjust.

The relevance between income growth and debt growth and between the growth in real estate assets and debt growth is stronger among households in the lower income quintile. This may be due in part to the increase in lifetime income, but considering the restrictions on their access to the financial market, the increase in income and real estate assets seems to have acted to mitigate those borrowing constraints. Meanwhile, in terms of real estate asset quintile, households in the middle and upper groups were found to take on more debt when their real estate assets grow, meaning that the interaction between asset growth and debt growth appears much stronger in the middle and upper groups.

According to the relative income hypothesis, it is expected that the larger the income inequality, the higher the increase in debt, particularly among low-income households. This study analyzes microdata on households to examine whether the increase in household debt is actually related to the economic inequality during the period since the early 2000s. When the data is compared by region, the analysis reveals no significant relevance between income inequality and the debt growth of low-income households in the same region. Also, there is no meaningful relevance between the inequality in household asset and debt growth in bottom-asset households. On the other hand, when the comparison is based on age group (nationwide), the analysis finds that low-income households of the same age group react to the income inequality within the group and respond by taking on more loans.

The recent slowdown in debt growth seems to be associated with the slowing growth in GDP as well as with the tighter mortgage regulations. But, as long as the real estate market is thriving, more debt may follow. Furthermore, the income gap within similar age groups may also likely drive up the debt in low-income households within the age groups. Accordingly, to induce a soft landing for household debt, the government should seek policy measures to stabilize the real estate market and to reduce the consumption gap stemming from income inequality in addition to tightening borrowing regulations.

Summary

Policy Study KOR Economic Growth and the Quantitative Expansion of Financial Resources

Based on Korea’s data, this study empirically analyzes the relationship between economic growth and the quantitative scale of financial resources. The scale can be measured in various ways, and this study uses one of the most important indicators applied in preceding literature, private credit as a share of nominal GDP.

The results show that the quantitative expansion of financial resources has a nonlinear effect on economic growth. When private credit (as a share of GDP) falls below a certain threshold, an expansion of private credit causes the mid-term economic growth rate (five-year average of per capita real GDP growth) to ascend―the reserve is true for when it exceeds beyond the threshold for the pertinent year. This finding implies that financial resources and economic growth are in an inverse U-shaped relationship. At the peak of the curve, the growth threshold of financial resources is estimated to be 117.2% in terms of the private credit to nominal GDP ratio.

Additional analysis of the nonlinear relationship found household debt to be a main casual factor. It was revealed that although financial resources can contribute to economic growth, the degree tends to decrease as the share of household credit in private credit increases. The threshold for the household credit ratio is estimated to be 27.8%. Private credit provided as corporate credit can contribute to economic growth but when that of household credit surpasses this figure, the increase in private credit can restrict it.

As of end-2016, the percentage of private credit exceeds 190% of GDP and the household credit ratio is near 50%, exceeding both thresholds estimated from the above analysis results. These results reaffirm that the qualitative development of financial resources needs more emphasis than the quantitative supply in the process of establishing future financial policies.

Summary

Policy Study KOR Transmission of Uncertainty Shocks in Korea: International Bond Market Approach

This paper addresses three issues on a relationship between uncertainty and business cycles in Korea.

First, focusing on a rapid increase in corporate bond issuance by Korean firms at international bond market, this paper proposes a new measure of domestic uncertainty using option adjusted spread of bonds issued by Korean firms at international bond markets. The domestic uncertainty is defined as a cross-sectional dispersion of corporate bond spreads.

Second, this paper investigates relationship between the measured domestic uncertainty and business cycles. Estimating a relatively simple forecasting regression, a one standard deviation increase in the domestic uncertainty is associated with 0.60, 0.89, and 1.74 percentage points decrease in GDP, domestic consumption, private investment growth, respectively.

In addition, estimating a relatively simple structural vector auto-regression model, a one standard deviation shock to the identified world uncertainty, represented by the VIX, and domestic uncertainty shock results in economic recession in Korea.

Lastly, this paper investigates the propagation of the world uncertainty through the domestic uncertainty channel to the Korean economy. In particular, the forecast error variance decomposition exercise suggests that approximately 75% of the world uncertainty is transmitted to the Korean economy through the domestic uncertainty channel.

This research adds to the literature by suggesting a new measure of uncertainty using corporate bond spread data. In addition, this paper contributes to the existing literature by highlighting the importance of the domestic uncertainty in transmission of the world uncertainty.

It is also worth noting that the proposed domestic uncertainty is relatively simple to construct. For the reason, it is expected that the policymakers could utilize the proposed domestic uncertainty in assessing the business cycle. In this regard, it is also expected that the domestic uncertainty would complement other business cycle indicators.

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

Policy Study KOR True Intention of Bagehot: Reinterpretation of the Theory of Lender of Last Resort in the Historical Context

Discussion on the role of public institute in the financial system first started with the formation of economics in the 19th century and is still on going. Around the 1960s, the discussion mainly focused on the monetary policy, but in recent years, the focus has been moving towards the functions of public institutions relating to risk management or lender of last resort, as inflation stabilized in recent years but the occurrence of financial crises is frequent since the growing trend of financial liberalization.
Today, three opinions, ‘market failure,’ ‘central position,’ and ‘free banking’ are being confronted. An interesting fact from the discussions among the three opinions is that they all have their theoretical roots in Lombard Street: A Description of Money Market (1873) by Walter Bagehot, a British economist in the late 19th century. For this reason, the interpretation of this book is often the target of their discussions, which implies that correct understanding of this book could offer some help in judging
which opinion is better or more accurate than the others. This also is the motive of this research.

The methodology that this research had adopted for better understanding of Bagehot’s lender of last resort theory is to analyze the historical space where Bagehot had belonged. To understand Bagehot, it is necessary to know the changes and subsequent problems the then British financial system had. To that end, the paper first monitors the environmental changes in the financial economy of the mid-19th century. Two changes this paper gives a particular attention to are the vitalization of liberal movement of
international capital and the advent and expansion of deposit banking system based on the factional reserve system. Because of these changes, the UK became the first to experience the internal and external instability of finance. There occurred frequent financial crises related to the instable international capital movement and large swings in business cycle related to the instable supply of domestic fund flow. Accordingly, then economic experts in the UK began to seriously consider the setup of monetary policy
to sustain economic stability and financial measures to counter financial crises under the domestic and foreign financial order of liberal creation and transfer of liquidity. This is the interpretation of this paper.

Facing these policy agenda, then economic experts suggested two conflicting opinions, one from the Currency School, the other from the Banking School. The winner of the discussion was the Currency School, and their opinions were incorporated into policy. They considered that at the bottom of the money supply shock lays financial crisis and a business cycle that includes the crisis. The excessive note issuance by the Bank of England (BOE) and local banks caused bubbles and its aftereffect was a financial crisis,
according to the supporters of the Currency School. In this context, they suggested as a best solution strict standards for the creation of liquidity by banks including the BOE. The significant reason that the Currency School opinions were dominant was believed to be that they well satisfied critical minds of then economic experts relating to the core problems. The UK, between the late 18th and 19th centuries was undergoing a transitional period from the metallic currency system—where gold or silver coins were
used as currency—to the mixed currency system—where gold coins and paper currency based on bank notes and deposit currency were simultaneously used.

The Currency School considered it most necessary to impose monetary discipline as the regulative measures to the creation of liquidity in any form in order to sustain the economic stability under the new economy trend. In addition, the Currency School’s mechanical argument on monetary policy theory was suggested not because they did not recognize the necessity of the function of the lender of last resort. The Currency School was already aware of the dynamic time inconsistency problem which is popularly understood
today. They thought, the moment when the Article of granting the application of bank note issuance rules in panic situation moral hazard could follow, threatening the establishment of the monetary discipline. In this regard, they believed that the answer to the problem of dynamic time inconsistency was a structure whose fundamental factor should be based on the ‘legislation of the currency policy rules without making conditions on exceptional cases in advance, and under which the policy authority exerts its
direct discretionary power under the surveillance of the legislator, the National Assembly, in responding to exceptional cases that require the application of the law. However, as it became legislated, the theoretical system of the Currency School had shown weaknesses that were evident. The problem of the importance of the deposit currency and the endogeneity of currency were supposed to occur in a later time, but the problem of financial crises and the exhibition of the lender of last resort function were realized
right away. Faced with the series of financial crises in 1847, 1857, and 1866, the responses of the EOB disappointed a number of people. The EOB did not expand the liquidity supply earlier, and at the last minute, the paralysis of the financial system was evident, the application of the law was suspended momentarily and the issuance of bank notes was expanded. The EOB’s expansion of liquidity supply worked to stabilize the crises, but an increasing number of people began to believe that the EOB’s responses
were not satisfactory. So far is the historical progress until 1873 when Bagehot wrote Lombard Street. For Bagehot, the most significant policy impression of the changes in the financial environment was the rise in the risk of financial crisis caused by panic. In particular, he emphasized the integration of the international capital markets and warned of the foreign exchange crisis brought on by the changes in credit rating and the subsequent risk of financial crisis. Bagehot’s recognition of higher risk of
the panic-caused financial crisis due to the changes in the financial environment, though stronger recognition, was not different from that of the Banking School, and the Currency School had not denied the risk. Not only that, Bagehot diagnosed that the application of the solution of the Currency School resulted in significantly weakening the UK economy’s risk management or the lender of last resort function. This diagnosis was already pointed out by the Banking School, but the difference in the Bagehot’s argument
was a completely new analysis method he used for the diagnosis. The responsive solution to the financial crisis supported by the Banking School was to tacitly let the government’s discretional authority handle the crisis. Bagehot argued that this solution triggered uncertainty and worked to aggravate the financial crisis, rather than stabilizing the panic-caused financial crisis.

The ‘tacitness’ and ‘uncertainty’ of the ‘dynamic time inconsistency’ by the Currency School might be able to mange the risk in the end, but Bagehot believed that during that process, the solution could expand the crisis risk while further increasing the cost of risk management. Based on this belief, Bagehot suggested new policy measures, which offered transparent policy goals and reform in the governance structure of the EOB. If the premise is that the EOB should aim at two goals of imposing currency
discipline and playing the role of risk management or lender of last resort, it is theoretically possible that pursuing these two could cause the ‘dynamic time inconsistency’ problem as the Currency School emphasized. However, the modern economics, since the 1980s found that if the goals of the policy authority are made clear for the general public to understand, the ‘dynamic time inconsistency’ problem could be solved by reputation. If this reputation mechanism works, it could bring far better outcomes in
the environment with higher uncertainty, compared to the standard solutions that significantly weaken the flexibility of exerting the discretionary power. This problem solving by the ‘reputation’ mechanism is what Bagehot suggested.

This study’s interpretation of lender of last resort by Bagehot is consistent with Bagehot’s interpretation of ‘market failure—one of the three modern economic theories. In that sense, Bagehot believed that the characteristics of financial market are difficult to explain with the perfection, and the rationality of the market constitutes an important part and that his perspective can be understood as the same with the market failure perspective. The same goes for his perspective that under the financial
environment ruled by uncertainty, the responsive instrument to deal with the panic-caused financial crisis should be implemented by allowing the relevant authority to exert their own discretionary power in principle but solving problems of moral hazard should be tried through the establishment of incentive structure.

Lastly, this study comments on the modernity of Bagehot’s argument. Bagehot is conveying two messages to people of today. First, under the environment where domestic financial market is liberalized and global capital market is integrated, the risks of the panic-caused foreign exchange crisis and the financial market co-exist. Second, in principle, dealing with such risks, the discretionary power of the policy authority should be guaranteed and the possible abuse of the power should remain controlled by the
reputation mechanism. In relation to this, Bagehot particularly emphasized that the authority holding the responsibility should be clearly identified, the operation of this authority should not be distorted by private and political interests, and its governance structure should be carefully designed to maintain its specialty and sustainability.

Summary

Policy Study KOR A Study on the Channels by which Stock Price affects Consumption in Korea

This paper studies the channels by which stock price affects the consumption in Korea. Regarding this theme, there are two main arguments: One is that fluctuations in stock prices produce capital gain or loss, resulting in either wealth gain or loss and the other is that the positive correlation between stock price and consumption only reflects the function of stock prices as the leading indicator of the future economy. The preceding studies show little more support for the former argument. However, the importance
of the capital market is on the rise since the foreign exchange crisis and its increasing efficiency indicate the growing likelihood of the role of the stock price as economic indicator.

According to the comparison of the residual correlation and impulse response function estimated by the VAR time-series model—during each period of pre-openness, pre-crisis, and post-crisis, the effect of consumption on stock price appears to move along with foreign and domestic stock prices and the sensitivity rise of consumption toward interest rates.

The analysis result using the urban household survey shows that regardless of income class the consumption tends to be rising at a similar pace with the rise in stock prices. Another analysis of the Korea Household Panel Study reveals that there are no changes found in the distribution of income classes holding stocks before and after the financial crisis, and that no differences are seen in consumption pattern between stockholders and non-stockholders.

All these results imply that in Korea the role of stock price as economic indicator is more important than that as a channel affecting consumption.

Also, as for policy authorities who face difficulties in accurately predicting business sentiment due to different release time between real economy, income and company’s profitability indicators, stock prices might function to offer useful information prior to the release of actual study results of consumer and corporate sentiment.

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