A review of capital inflows in Korea and Thailand

Two speeches. One by Korean Central Bank Governor Chogsoo Kim and other by Bank of Thailand Deputy Governor Dr. Bandid Nijathaworn. Both highlight the risks from capital inflows and managing impossible trinity in their economies.

First Korea. Kim says there are two issues – First capital flows are procyclical and second managing them leads to working against impossible trinity.

Once their capital markets are liberalized, capital flows bring about increased  economic volatility. Capital flows are essentially pro-cyclical. Put more simply,   capital inflows surge greatly during economic booms, but decline or go into  reverse during economic slowdowns.

Another problem arising from cross-border capital flows is the worsening of  conflicts between a country’s internal and external policy goals. In an open  economy, it must seek to resolve what is termed the “impossible trinity”. In  this, one of three desirable goals – capital market opening, fixed and/or stable foreign exchange rate, and monetary policy autonomy must be sacrificed if the two others are to be achieved. Thus, once capital market opening has progressed, a dilemma arises –  a choice between foreign exchange stability and monetary policy autonomy.

He then tracks how cap flows have behaved over the years in Korean economy.  It has been  a case of pure procylicality.  They first increased before SE Asian crisis, dried in the crisis. Then again picked up as Korean economy recovered and dried up after Lehman. And have again picked up now. This time the nature of flows are different:

In contrast to the period before the global financial crisis, the recent capital inflows to Korea have had the following features. First, while banks’ borrowings have increased only slightly, equity and bond investment inflows have both expanded on a large scale. Second, the proportion of long-term bond investment has increased. In terms of region, meanwhile, the source of inflows has diversified to include Asian countries as well.

Influenced by the abundant capital inflows, domestic stock prices have risen sharply, the Korean won has appreciated against the US dollar and long term interest rates have fallen. This has led to a tri-polar bull market – in FX, equities and bonds. The other side of the coin is that the financial market could turn highly unstable upon any sudden negative shift in domestic or  international conditions.

This is quite similar to India as well. Here too credit has not picked up and bulk of financing happening via non-banking sources. And there are pressures everywhere. Only Bond market outlook is bad because of high deficit liquidity and inflation worries.

‘BoK has acted to dampen the flows a bit:

As part of a bid to forestall such an eventuality, the BOK worked with the Korean government to introduce, this June, macro-prudential measures to mitigate the volatility of capital flows. The main goal of the measures is to minimize systemic risk in the Korean economy and bolster its macro-prudential soundness.

A new system of ceilings on banks’ FX derivatives positions was built to curb excessive short-term overseas borrowings. FX derivatives positions traded before its introduction will of course be allowed to continue to maturity. Regulations on foreign currency loans were tightened as well, to guard against the possibility of increased demand for them due to the recent strong economic growth. Since July, their use has been restricted to overseas purposes only.

Will RBI act too in Nov 2 policy like BoK?

Kim adds that best options to mange the risks of sudden stop and impossible trinity are sound macro policies and look at macroprudential tools. Then global cooperation is important as well:

Last but by no means least, it is necessary to strengthen international cooperation. Given the current environment of financial globalization, it is no longer possible for any individual country to fully manage cross-border risk on its own. And in this regard the global financial safety net, which at Korea’s initiative has been placed on the agenda for the upcoming G20 Summit, can, I feel, effectively complement precautionary foreign reserves and lead to capital market stability eventually.  

BoT Deputy Governor also begins with the same ideas. He says capital inflows pose two challenges. One is a dilemma between inflation, appreciation and growth prospects. Two is financial stability.

He says cap inflows are nothing new but this time there is some difference this time with nature of flows:

First, compared to previous episodes, capital inflows this time are not country-specific that relate to the financing of payment deficits. Instead, capital inflows this time are a global phenomenon propelled by near zero policy rates and liquidity expansion in the advanced economies

Second, given that financial markets have become more integrated and more interconnected than ever before, the risk to economic and financial stability associated with capital inflows this time is also much greater.

And third, while the forces underlying the current cycle of capital flows are global, policy response in emerging economies remains domestic-centric. This, I think, is an important point to note in the current capital flows episode. Also, because financial markets are more integrated, policy response in one country can have significant unintended consequences on other economies. In other words, we are living in a world where events and policies in a country can result in large spillover effects on other economies.

He then moves to macroprudential policies of BoT.  He says there are three key features of macropru policies in Thailand:

First, it is important, in the context of public communication, to make a clear distinction that macroprudential measures are different from capital controls. Technically speaking, macroprudential policies apply to the calibration of regulatory measures from a system-wide perspective to dampen procyclicality arising from the interplay between the business cycle, the financial cycle, and risk-taking behavior of economic agents. Given such interpretation, measures to curb or discourage capital inflows should be considered as capital account measures and not macroprudential. For example, Thailand’s recent measure to reimpose withholding tax on non-resident investment in the bond market is a policy to discourage capital inflows.

Second, macroprudential measures work by reducing systemic risk across the financial system. To this end, they are useful tools to lean against the wind of excessive credit growth and asset price increases. As we know, monetary policy alone is not adequate to ensure financial stability, and the policy rate can be too blunt a tool to deal with asset price increases

To date, we have successfully used macroprudential measures on several occasions. For example, in 2003, rising high-end real estate prices together with strong mortgage lending growth led us to impose a ceiling on the loan-to-value (LTV) ratio for residential property with transaction price exceeding ten million baht. Then, between 2004 and 2005, concern about household debt prompted us to tighten regulation on credit cards and personal loans by limiting credit lines not greater than five times the applicant’s average monthly income.

My third comment is to acknowledge that there are practical difficulties in identifying the trigger points for implementing macroprudential measures. Here, the challenge lies in selecting a set of indicators that can condition a timely policy choice, given the discrete nature of the instruments. To this end, we have put in place a macro-surveillance system to monitor vulnerabilities in seven key areas; namely, property market, stock market, banking sector, non-financial corporate sector, household sector, government sector, and external sector. Indicators are used to evaluate the build-up of vulnerabilities and imbalances in these sectors and the need for macroprudential measures is then assessed. This ultimately boils down to a judgement call.

Interesting stuff. Communications are important about which measure is for macropru and which is capital controls. These are interesting examples from Thailand. Even India passed some macropru measures in 2007 just like Thailand.

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