KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Policy Study KOR Strengthening Macroprudential Management for Non-Bank Financial Institutions in Korea: Focusing on the Issuance of Equity-Linked Securities (ELS)

This study proposes measures to strengthen macroprudential management for non-bank financial institutions (NBFIs), such as securities firms and insurers, whose importance has grown since the 2008~2009 Global Financial Crisis. Major economies and international financial institutions have actively discussed and pursued new or enhanced supervisory and regulatory frameworks for managing NBFI-related systemic risk.

Using ΔCoVaR, a leading systemic risk metric capturing changes in conditional value at risk, this study analyzes the evolution of systemic risk among South Korea’s banks, securities firms, insurers, and individual financial institutions during major financial shocks, including the Global Financial Crisis, the European Debt Crisis, and the COVID-19 pandemic. Findings reveal substantial increases in systemic risk across all sectors during each crisis, with banking generally exhibiting the highest levels. Sectoral differences varied, with risk for securities firms surging during the March 2020 margin call event, markedly narrowing the gap with banks compared to previous crises.

The study further empirically examines the impact of Equity-Linked Securities (ELS) issuance by financial institutions on systemic risk (ΔCoVaR). Results indicate that increased ELS issuance contributed significantly to heightened systemic risk during the Global Financial Crisis, the European Debt Crisis, and the COVID-19 crisis. These findings underscore the growing importance of NBFIs in macroprudential management and call for systematic monitoring with enhanced regulatory oversight of the non-bank financial sector.

Summary

Policy Study KOR Investor Composition of Government Debt and its Fiscal Implications

This paper estimates the demand for South Korea’s government bonds across investor categories and projects future bond yields in light of the country’s rising debt trajectory. A cross-country analysis shows that public and non-bank sectors have been key drivers of increased foreign investor holdings of Korean government debt during the COVID-19 pandemic. Using sectoral debt holdings data, the paper examines the evolution of marginal holdings of government bonds by each sector and estimates the responsiveness of debt demand to bond yield changes. Over the past decade, domestic banks and public institutions, including the National Pension Service, have reduced their marginal holdings, while private pension and investment fund sectors have increased theirs. These findings highlight the growing importance of non-bank sectors in government debt demand, consistent with the literature (Fang et al., 2022). Foreign investors exhibit the highest demand sensitivity to bond yields, whereas domestic insurance companies show the lowest. Based on sectoral demand estimates, a 10% increase in government debt is estimated to raise bond yields by 43 basis points. By 2030, when Korea’s government debt is expected to reach 2,000 trillion won, bond yields are projected to rise to 4.85%, ceteris paribus. Notably, 60% of the projected yield increase is attributed to the inelastic demand of insurance companies. This underscores the importance of adjusting the investor composition of the government bond market, with a greater share of investors with higher demand elasticity to alleviate pressure on borrowing cost.

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Policy Study KOR Capital Flows and Challenges in the Digital Age: Focusing on Central Bank Digital Currencies (CBDCs)

As the digitalization of finance accelerates, discussions on the adoption of Central Bank Digital Currencies (CBDCs) are gaining momentum, particularly among G20 nations. This development calls for examining the potential impacts of CBDC implementation on both domestic and international financial markets and capital flow, alongside exploring appropriate response strategies. Upon reviewing the status and background of CBDC adoption among G20 countries, setting up a unified CBDC platform for this group in the short term is highly unfeasible. Instead, some emerging economies are expected to introduce retail CBDCs to enhance payment infrastructure or conduct experiments linking wholesale CBDCs for cross-border payments. Should CBDCs be adopted globally, the speed and scale of international capital movements could increase, potentially amplifying the volatility of capital flows and currency values. In order to ensure the effectiveness of capital flow management policies already in place, it is crucial to foster close cooperation between major central banks on CBDC integration. Moreover, efforts should be made to maximize the benefits of the new payment systems introduced by CBDCs. These efforts include revising financial regulations and upgrading infrastructure by implementing open foreign exchange regulations, maintaining balanced oversight of fintech firms, and enhancing the efficiency of existing payment and settlement infrastructures.

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

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

Policy Study KOR The Effects of US Monetary Policy on Gross Capital Flows: Cases in Korea

There are claims that US monetary policies generate global spillovers and destabilize small open economies. Accordingly, the effects of identified US monetary shocks on Korea’s gross capital flows were analyzed using the local projection method. Consistent with previous results on other small open economies, we confirm that US rate hikes are dynamically correlated with foreign outflows and resident inflows. That is, not only is there a correlation with the withdrawal of foreigners, but also with those of domestic (Korean) investors; primarily driven by portfolio flows. However, the marginal response to the shocks has been subdued in the sample periods following the Global Financial Crisis. A possible reason behind the change may be the institutional shift in regards to financial friction. If the degree of pledgeability on the value of net worth increases, the marginal response of investors will drop on a US monetary shock which is in line with our findings.

Summary

Policy Study KOR Risks in International Capital Flows: Foreign Investors’ Behavior in Korean Stock and Bond Markets

This paper studied the pattern of international capital flows in Korean financial markets to analyze their risks. In particular, this paper focused on foreign investors’ behavior responding key investment factors in Korean stock and bond markets, in which capital flows have become more volatile recently. It was found that foreign investors tended to retrieve their investment when global risk aversion (VIX) was high or when global liquidity (the U.S. short- term interest rate for stock markets and global money supply for bond markets) was reduced. The response to VIX was statistically significant in stock markets, but the significance level in bond markets was relatively low. This result reflects that foreign investors consider Korean bonds to be safer than Korean stocks are. This paper, in addition, founded that the significance levels are different across global liquidity indices, which implies that each index reflects different aspects of investment factors and hence investors respond accordingly. For domestic economic fundamentals, rather, foreign investors tended to retrieve their investment when the coincident indicator of business cycle improved. It is interpreted as domestic economic fundamentals are more important investment factors to domestic investors than to foreign investors. That is, in adjusting portfolios foreign investors put more weights on global factors whereas domestic investors on domestic factors.

Next, this paper explored the association between capital market openness and the pattern of international capital flows. In Korean stock and bond markets, foreign investors’ response to global risk aversion (VIX) is not significantly associated with capital market openness; that to global liquidity (the U.S. short-term interest rate for stock markets and global money supply for bond markets), however, was greater as capital markets were more integrated. It suggests that as capital markets are integrated, foreign investors’ response to some global factors might increase.

This paper also showed that foreign investors’ behavior in Korean stock and bond markets might be different by their nationality. In particular, it was found that it is difficult to identify the risks by looking just at relative volumes or relative volatilities across investors’ nationality. This paper, therefore, suggested that it is insufficient to analyze only total international capital inflows and it is necessary to understand the specific properties of international capital flows with disaggregated data.

Summary

Policy Study KOR Global Transmission of Financial Instability

This study aims to understand the transmission of financial turmoils across countries by analyzing the co-movement of stock markets. In addition, it attempts to figure out how the Korean stock market is exposed to the global markets by assessing potential determinants of the co-movement between Korean and the U.S. stock markets. Based on these results, policy implications are discussed to mitigate the international transmission of financial turmoils.

The DCC-GARCH model is employed and estimated to analyze the international co-movement of stock markets. It is found that the synchronization of volatility and returns of stock markets across countries have been strengthened while volatilities have converged to a similar level for major countries after the global financial crisis. In addition, common shocks seem to have contributed most to the strengthened synchronization of stock markets if shocks to stock returns were broken down into common and idiosynchratic components. Furthermore, the enhanced co-movement between stock markets during the global financial crisis can be explained by the worsening conditions of the short-term credit markets and the increased uncertainty of the global financial markets. These results imply that international cooperation may be sought to mitigate the international spillover of financial turmoils. Also, each country’s efforts could be sought to mitigate the negative impacts of the global financial turmoils as sovereign risks and foreign investors’ trading volumes may contribute to the propagation of financial turmoils.

Summary

Research Monograph KOR Challenges and Development of China's Financial System: Policy Implication on the Korean Economy

With the global financial crisis in 2008, the political and economic status of China has been greatly advanced. Recent steps China has taken throughout the fiscal crisis in Europe have also drawn increasing attention across the world. Despite its fairly large economic proportion (10%) in the world, China has shown imbalanced development between its real economy and finance, which is considered as potential risk factors of the Chinese economy. Recognizing this, KDI initiated a joint research project in the name of national strategy development with China. This paper takes China’s viewpoint to address current status and problems of China’s financial system and projects future macroeconomic, financial and foreign exchange policies and their impacts.

From the Western point of view, China’s financial system is imperfect and inharmonious, which is mainly attributable to the gap between the real economy and finance. Such characteristics can be largely summarized as follows.

First, in China, interest rates and exchanges rates, which are the major prices in the financial market, are determined by the policy authority, but commodity prices are determined by market supply and demand. The recent price hike in house prices can be explained particularly by the rapid rise in mortgage loans. On the other hand, interest rates are maintained low isolated from the market interest rates and therefore are short of stabilizing house prices.

Second, China’s commodity market is completely open domestically and internationally, but its financial market remains still under control. The reason that the financial market of China was hit relatively less by the global financial crisis in 2008 is ironically due to its closeness to the outside world. However, it is increasingly difficult for such regulation on the financial market to be continued since the Chinese economy accounts for growing portions of the global economy. Such controlling regulations could serve to hinder a further leap forward and development of China.

Third, the state-owned commercial banks hold a monopolistic power of operating the indirect finance-oriented system. The monopolistic structure of the state-owned commercial banks means that the financial system is de facto directly controlled by the policy authority, which could cause moral hazards leading banks to produce non-performing assets on a regular basis.

China has successfully overcome three crises in 1989, 1998 and 2008. The crisis in 1989 was overcome through the policy of openness addressed in Deng Xiaoping’s speech in southern China. During the East Asian financial crisis in 1998 and the global financial crisis in 2008, China even sustained its exchange rate and expanded fiscal spending, serving to help other countries to recover from their economic crisis. It is of course true that China’s overcoming the financial crisis is largely due to its closed financial system, but fundamentally speaking, the Chinese financial market is fully controlled by the government, making it possible for effective management to take a leading role in the face of the crisis.

However, the China’s financial system is expected to face following risks. First, given that it is inevitable to relieve regulations on the financial market at home and abroad as the financial system is developed, it is doubtful that the Chinese government will lead the reform of financial system in a way that could minimize adverse effects. Second, when it comes to a strategy of RMB internationalization, the necessary liberalization of capital markets will pose new challenges to China. Third, as the commodity market moves further towards openness and marketization, there will be unprecedentedly stronger tendency of economic agents such as individuals and local governments to seek profits, potentially leading to financial delinquency problems due to their excessive risk-taking activities.

China’s macroeconomic imbalance and policy changes may produce new risks, but it does not seem to trigger a crisis in China’s financial system. That is largely due to the fact that the Chinese government has risk control and management capability. Under such context, the paper assumes the case of economic or financial crisis of China when an initial impact comes from the outside, and then amplifies further by its own internal mechanism until spiraling out of the government’s control. For instance, it is the case where the ongoing economic recession worldwide and Europe’s fiscal crisis contracts the global demand, exerting severely negative impacts on China’s high export dependency. When inflation?which is directly related to the survival of grassroots people of the society?rises at a fast pace, therefore easing monetary policy is difficult. A rapid fall in prices of real estate properties, which were excessively invested could trigger a sharp rise in non-performing assets of commercial banks and rural and urban credit cooperatives, leading to a credit crunch. When contraction of the real economy and credit crunch occur simultaneously, coupled with a failure of policy coordination due to conflicting interests between the central and local governments, this could become a crisis affecting the whole economy. This scenario is, of course, based on extremely pessimistic conditions with very low probability, but instead suggests the possibility that the cause of a crisis could come from the outside and lead to amplifying internal conditions.

Despite such possibility of risk transfer, it is recommended that for at least medium and long run, Korea needs to pursue a strategy of actively seeking for opportunities and not remain concerned over the risks posed by China. The 12th Five-year Plan (2011~15) of China includes financial sector development as its major agenda to enhance efficiency of the financial supervisory authority as well as to establish a multi-layered financial market system. Depending on the economic and income growth, it is highly likely that China will show a rapid growth in its stock market and individual financial markets including asset management and insurance. In this regard, by advancing into the Chinese financial market, Korea’s financial institutions can become a global financial company using this opportunity as a growth engine. Therefore, it is necessary to add stipulations on further openness of China’s financial sector in the currently ongoing China-Korea FTA negotiations.

Summary

Policy Study KOR How does Short-term External Debt Affect the Korean Economy?

It is an undeniable fact that short-term external debt may pose a serious threat to Korea’s financial system. External short-term debt in foreign currency could put a heavier burden on the financial system by causing maturity and currency mismatch depending on banks’ management system on foreign currency funds. Also, a rapid outflow of short-term foreign debt could lead to a crisis in foreign currency liquidity.

To prevent such risks, it is necessary to understand the management methods of banks on short-term external debt. Most of Korea’s short-term debts go through an intermediary process of banks and the degree of risks is determined by the types of intermediary process. For this reason, this study examines the following issues: the types of intermediary process that banks use to manage short-term debts, and the status of each type, risks and benefits produced. In particular, by analyzing the panel data of banks, the study also examines which type turns out relatively significant and statistically meaningful, and then based on the result the study draws implications for relevant policies.

Above all, based on the status of banks’ main foreign asset management, this study finds that the main methods for managing short-term debts are the provision of foreign currency denominated loans to real sectors—such as export-import finance, foreign currency loans and foreign currency securities—and the provision of foreign currency to financial sectors—such as interbank loans in foreign currency and monetary derivatives. The analysis on the status of foreign asset management and monetary derivatives by domestic banks and branches of overseas banks reveals that short-term debts by domestic banks are likely to be injected into real sectors which are deemed to bring relatively positive impacts on the Korean economy, whereas branches of overseas banks are more likely to use short-term debts for managing monetary derivatives. The study also estimates an econometric model using banks’ panel data in order to gain more detailed results, and the analysis finds that as for domestic banks, the management through real sectors such as export-import finance and foreign currency loan turns out to be more significant than other methods as expected initially, whereas for branches of overseas banks, the management through foreign currency loan turns out to be more important than interbank loans in foreign currency and monetary derivatives.

In this context, it would be appropriate that regulations on short-term debt needs to be steered in a way that could prevent short-term debt risks such as maturity and currency mismatches and at the same time, could allow benefits from short-term debts. In other words, given that the Korean economy is already provided with short-term debts through various management methods, the regulations need to be able to allow methods that could offer benefits to the Korean economy, for example, by foreign currency denominated loans to real sectors, while at the same time limiting methods such as monetary derivatives, which deemed to have comparatively less or unclear benefits. Likewise, risks factors need to be considered when deciding on the magnitude and scope of regulations. Based on this point of view, recent regulations on short-term external debt seem to be set towards a proper direction in terms of risks and benefits of various management methods. However, it may be necessary to consider revising the base rate of Bank Levy so that private and social costs held by users of foreign fund would become equal in the long run.

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