KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Policy Study KOR The Impact of External Uncertainty Shocks in Korean Economy

This paper explores the effects of external uncertainty on South Korea’s real economy. By exploiting variations in geopolitical risks posed by Russia and the uncertainty surrounding US monetary policy ― both of which are plausibly exogenous to the Korean economy, the study reveals that such uncertainties negatively impact Korea’s key domestic macroeconomic variables. Notably, this adverse effect is distinctively evident in sectors like exports and manufacturing due to their high sensitivity to external demand dynamics. Using micro-data, the study further indicates that external uncertainty significantly reduces (i) exports to low-income countries and (ii) exports of capital goods. Additionally, the analysis confirms that financial constraints and the irreversibility of investment decisions play pivotal roles in amplifying the effects of external uncertainties.

This study enriches the existing literature by quantifying the impact of external uncertainty using novel instruments ― the geopolitical risk emanating from Russia and the uncertainty surrounding US monetary policy. These findings can offer insights that can guide the formation of resilient policy, aptly designed for a dynamic external landscape, while providing a comprehensive understanding of how external uncertainty influences real economy at both macro and mirco levels.

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 Fiscal Policy in Open Economies: Capital Accounts and the Crowding Out

We analyze the effect of fiscal policy of open economies, and examine the effect of fiscal policy on domestic corporate investment. Capital flows are important factors in determining the effect of fiscal policies in a small open economy. Fiscal expansion which tries to boost overall demand could, in principle, be restricted by various factors. So-called crowding-out could reduce the effectiveness of fiscal expansions, and thus lower the fiscal multiplier. Capital flows could play an important role in determining the effects as it determines how the revenues for fiscal expansion are financed. Here, we examine the magnitude of the fiscal multipliers with different states of capital flows. Through the structural vector auto regression (SVAR) model using the sign restriction on national panel data from 42 countries, we find that fiscal multiplier is higher when capital inflows and lower when it outflows. And the responsiveness of different states of capital flows are more notable in investment than in consumption, the other component of GDP accounts.

In the second part of the paper, we further examine the corporate investment of Korea. If the crowding-out prevails, fiscal expansions could lower the overall investment. Increased supply of government bonds will substitute corporate bonds in the loanable funds market. However, if it could partially be off-set if firms could fund their investment from international investors. That is, if individual firms could finance their investment from external funds, it could unwind the crowding-out of the fiscal expansions. We analyze Korean firm level data from 2005 to 2020, and confirm that with fiscal expansions, investment ratio decreased especially in companies with high debt-to-equity ratio. However, those negative correlation is not observed in a sample of companies which hold foreign debts or have foreign main banks.

Summary

Policy Study KOR External Capital Accounts and Macroeconomics: Capital Flows and Aggregate Productivity

We examine the correlation between aggregate productivity and inefficiencies in the distribution of a production factor, capital. We also discuss how these misallocation of capital is correlated with capital flows. It has been well known that the growth rate of the Korean economy has declined over the past 20 years. Using ORBIS company data, we confirm that the marginal revenue productivity of capital productivity has been continuously rising since 2002. We argue that the pattern signals the rise of capital misallocation, which could hamper the aggregate productivity growth. Furthermore, comparing with other ten countries, we show that the Korean economy exhibits a tendency to show the GDP growth rate decreas with the increase of the dispersion of MRPK(marginal revenue product of capital). Also, the economy tends to show the increase of the dispersion of MRPK(marginal revenue product of capital) when net capital inflows increase. We note that we are abstract from the causality or full dynamic system of the aforementioned macroeconomic variables, which we will remain for the future research.

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 Reserve Accumulation and Investment: Evidence from Korean Firm Level Data

We empirically examines how foreign exchange reserves are associated with firm-investments using Korean firm-panel data. In national accounting, foreign reserve accumulation are increases in savings on foreign safe assets. Thus in principle, increase in foreign reserves could crowd out domestic savings on physical investments (firm-investments), if total savings are fixed.

Analyzing a firm panel from 1994 to 2017, we confirm that increases in foreign exchange reserves, if combined with high short-term debt, are correlated with decreases in corporate investments. The results, however, mainly come from non-exporting firms and disappear in the sample of exporting firms. We argue that nominal depreciation which comes with reserve accumulation might increase the profitability of exporting firms, which blur the effects of crowding out.

The empirics that growth rate of total factor productivity indeed has increased while foreign reserves increased could be supporting evidences that over-investment in physical capital before the financial crisis has replaced with investment on external safe assets after the crisis.

Summary

Policy Study KOR Influence of Global Investment Sluggishness on Value Added Inducement in Korea

A major driver of the downturn in world trade volume relative to global GDP, this study analyzes the impact of the slump in global investment following the global financial crisis on Korea’s economy. Accordingly, efforts were made to quantitative analyze the possibility that the global economy may be adversely affecting the Korean economy through the export path, as more heavily export-dependent value added is created.

The analysis reveals that the slump in global investment after the global financial crisis has had a particularly negative effect on the growth of the Korean economy than other economies. This is because the creation of value added is more dependent on global investment. Simulation results show that the decline in Korea’s economic growth rate is spurred not only by the slowdown in global economic growth but also by the decreased proportion of the investment sector in the global final demand. Indeed, the share of global investment in the global final demand diminished in the wake of the global financial crisis, causing the Korean economy's annual growth rate to decline by 0.21%p annually during 2008-14. An examination into the impact of the global investment slump by industry found that Korea’s major industries were dealt a particularly harsh blow, including electrical and electronic products, machinery, metals and transportation equipment.

Sluggish global investment can be attributed to both short-term and structural factors. The accelerating momentum of global aging and slowing productivity will likely continue to weaken global investment demand. And the fact that China, Korea’s biggest exporting partner, is reorganizing demand from investment to consumption, could also negatively affect global investment demand for a considerable period of time.

In order to tackle the problem, efforts must be made to create a malleable industrial structure capable of flexibly responding to the changes in the external environment. If Korea’s industrial structure is overly rigid, production resources will be continuously injected into a declining industry, and thus, promising industries may lose the opportunity to grow soundly. Therefore, policy efforts are required so that limited resources can be efficiently utilized by actively promoting the restructuring of insolvent companies and flexibility of the labor market. In addition, inroads for consumer goods exports should be aggressively pursued in major export markets like China, whose demand structure is shifting toward consumption.

Summary

Policy Study KOR Exchange Rates and Macroeconomic Stability: Implications for Contract Dollarization

Although exchange rate fluctuations are generally perceived as mechanisms that resolve the imbalances between countries, the resultant inefficiencies also call for attention. In order for fluctuations to fully resolve cross-border imbalances, they must first have a direct impact on countries’ relative product prices. However, the degree of fluctuation can vary depending on the contract currency in the terms of trade. Accordingly, this study aims to comparatively analyze the macroeconomic implications, in the context of social welfare, of exchange rate fluctuations prompted by diverse monetary policies implemented in response to both internal and external shocks. Given that the degree of fluctuation is contingent on the foreign exchange contract, this study also considers that it may affect how much a currency is reflected in the consumer price. Specifically, countries lacking in key currency, like Korea, are dependent on the foreign exchange rate. This, in turn, gives rise to price rigidity, which ultimately results in price misalignment caused by the differing prices of a product from one country to the next. Additionally, from a foreign consumer’s perspective, the short-term impact of exchange rate fluctuations on the relative price at home and abroad is almost negligible. As such, the expenditure switching decelerates and imbalance is insufficiently resolved.

This study examines the fluctuation of key macroeconomic variables and the exchange rate of three internal and external shocks: domestic productivity, overseas productivity, and overseas interest rate. For monetary policy, domestic inflation targeting, consumer price index price inflation targeting, the Taylor Rule, and the fixed exchange rate system were established as comparisons. Additionally, variations of the settlement currency of domestic companies’ exports were used in the analysis.

The results show that in the wake of the aforementioned shocks, domestic inflation targeting is the most desirable policy as it has the highest impact on social welfare. Although the fixed exchange rate system does not generate inefficiencies that accompany price misalignment, it creates unnecessary price dispersion between domestic products, which nevertheless results in inefficiency. Furthermore, the fixed exchange rate system is futile in reducing the volatility at home as it intertwines the domestic and overseas interest rates. However, by firmly maintaining domestic inflation targeting, inefficiencies that manifest between domestic companies can be effectively curtailed while the GDP gap can be also reduced; of course, the degree may differ based on the type of shock.

Indeed, the above results are generally in line with existing research that call for domestic inflation targeting. This is because, in terms of social welfare, despite the inefficiencies generated by settling payments with international currencies, it is more important to eliminate the inefficiencies created by discrepancies in domestic companies’ production levels and the overall production level of the economy. Also revealed is that, even though it is impossible to totally eliminate inefficiency with exchange rate fluctuations alone, exchange rate fluctuations can significantly resolve imbalances.

Summary

Research Monograph KOR Integration Strategy for East Asia(Ⅱ): Focusing on Korea, China and Japan

For a middle power nation to survive while accommodating changes in the international political and economic order as well as pursuing a sustainable growth, Korea need to develop a regional integration strategy for East Asia, which could be the Asian version of the EU strategy and actively push forward.

This three-year study project includes research on the integration strategy for East Asia, designing cooperation challenges to push forth international community of Korea, China, and Japan, and exploring external strategies as well as Pan-Asian integration in a step by step manner.

The first study in 2010 re-examined preceding studies and recommendations relating to East Asian integration and analyzes EU cases. At the same time, the study also intended to establish an integrated strategy of growth-stability-solidarity based on the framework suggested by Korean independence fighter Ahn Jung‐geun. The study specifically analyzes the significance and conditions for integration and then studies the development strategy for a community supported by the three axes of economic interests, political willingness and social cohesion. Also, following the projection on the effect of economic integration on the Korean economy, the study lastly explores Korea’s role in the integration process and suggests vision and philosophy on integration, along with implications on the need to strengthen Korea’s leadership.

This paper is a part of the second-year study, which explores an East Asian Integration strategy with its focus on Korea, China and Japan, three major Asian nations that are closely related in political, economic and social & cultural arena. Part Ⅰ, following the previous year’s study, continues to suggest the future direction of East Asian Integration and analyzes determinants for encouraging the integration. Part Ⅱ deals with the present state of cooperation among the three nations in the areas of politics & diplomacy, monetary & finance, education, culture, and environment. Measures to enhance cooperation are suggested, as well. Meanwhile, it should be noted that regional integration in this paper cannot be an issue of Korea alone and positions and viewpoints of neighboring nations should not be overlooked in the integration process. Part Ⅲ analyzes perspectives on the integration suggested by researchers from the three nations. Part Ⅳ summarizes the outcomes of the second-year study and attempts to provide policy implications.

Policy implications suggested in the 2011 study for East Asian integration strategy can be summarized under two categories: A need for a comprehensive approach and the establishment of a scheme. First, the cooperation between Korea, China and Japan extensively encompasses politics & diplomacy, culture, education, environment as well as economy. As shown from the empirical diagnosis, for a conclusion of regional agreements, the proximity of not only economic but also political diplomacy and cultural factors is highly significant. Such comprehensive approach is also consistent with the three-pillar approach of growth, stability and solidarity, which was promoted by the first-year study of this project.

To effectively pursue East Asian regional integration, the short-term strategy needs to be focused on laying the foundation for regional integration by creating common interests through economic integration, the medium-term strategy needs to build a closer tie between members by promoting social and cultural conversion, and the long-term strategy needs to secure stability that will help manage East Asia’s geopolitical conditions in a stable manner by including political and diplomatic issues as integration targets. In this aspect, efforts to improve the proximity between three countries should be put in simultaneously for key areas, including politics & diplomacy, education, culture and environment. As French economist Jean Monnet put it based on the experiences of Europe’s monetary integration, the remark, “Nothing lasts without institutions,” is also true to Korea-China-Japan cooperation. At the current stage, it is possible to establish an inter-governmental economic and social policy consultative organization sharing common values of open market economy and pluralistic democracy, which is absolutely consistent with the OECD’s goal which pursues common stability and prosperity by seeking a best possible policy solution to shared problems and mutually coordinating policies of the concerned parties. The next stage is to consider institutionalization similar to the EU. To that end, a supra-national discussion is required among the three nations. However, without consideration of existing obstacles to cooperation, setting a goal for integration which includes supra-national discussion is only likely to undermine existing cooperative relationship. Therefore, it would be appropriate to achieve an institutionalization similar to the level of OECD in the short run, while pursuing an institutionalization similar to the EU in the long run.

Summary

Policy Study KOR International Interest Rate Shocks and Monetary Policy under Small Open Economy

Fluctuations in international interest rates and terms of trade have been pointed out as significant international price variables that could cause fluctuations in a small open economy, and recent studies show that a considerable part of fluctuations in small open economies could be explained by international interest rate shocks.

However, despite study results emphasizing the importance of international interest rate shocks as a factor behind the fluctuations in small open economies, few preceding studies have intensively analyzed the implications of it. In this context, the study sets a standard small open economy theoretical model which holds the changes in international interest rates as exogenous variable, and based on this model the study uses a simulation methodology so as to quantitatively examine implications of various monetary policies in terms of social welfare.

The result of this study can be summarized as follows.

First, as for the economy in which international interest rates serve as a major factor behind economic fluctuations, it is found that inflation targeting based on a flexible exchange rate system produces more superior outcomes than that based on a fixed exchange rate system. Also, among the flexible exchange rate-based inflation targeting systems, inflation targeting on domestic goods turned out to produce more social welfare outcomes, compared to that on consumer prices.

Second, as for the economy in which international interest rates serve as a driving force of economic fluctuations, it is found that when operating the monetary policy rules in the form of flexible exchange rate-based inflation targeting system, the monetary authority would face tradeoffs between the benefit of the total demand stabilization by the buffering changes in overseas demand caused by movements in nominal exchange rates and the cost of increased instability of inflation caused by price changes in import goods. It is also found that the relative superiority in terms of social welfare that the monetary policy rule in the form of inflation targeting system has on the fixed exchange rate system depends on, which between the benefit and cost, turns out to be more dominant in the above tradeoff relationship.

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