Interest Rate and Capital account Liberalization in Korea

1
Interest Rate and Capital account Liberalization
in Korea

• By
• Lee, Heung-Mo
• (Bank of Korea)
• Presentation by Dong Wook Shin,
• Chun Kwon Yoo

2
Introduction

• Interest rates liberalization
• Interest rates liberalization had been
  implemented from
• the early 1980s till mid-1990s.
• - Now, all lending and deposit rates are
  liberalized except
• some demand deposits.
• The main purpose of interest rates liberalization
  was to
• cope positively with the global trends
  toward
• liberalization and market opening.

3

• Capital account liberalization
• Capital account liberalization started at the
  early 1990s and
• was motivated by the external factors.
• The external factors to widen capital account
  opening
• are as follows
• - bilateral negotiations with the advanced
  countries for
• financial market opening
• - launch of the WTO
• - Koreas entry to the OECD
• - outbreak of currency crisis in 1997

4
Implementation of interest rates liberalization

• The first half of the 1980s
• The first attempt was the introduction of CP
  (Commercial
• Papers) at unregulated rates in 1981.
• - The scale of CP market was greatly
  expanded.

The initial interest rates liberalization at
that time was rudimentary in form.
5

• A band system for banks loan rates was
  introduced in
• 1984.
• - Under this system, banks were permitted to
  charge
• differentiated rates based on
  borrowerscreditworthiness.
• - But most of the banks set their lending rates
  near the
• upper limit of the band, so the system did
  not succeed
• in effect.

6

• Liberalization in December, 1988
• Most lending rates were freed up at the same
  time.
• Rates on banks' long term deposits were
  liberalized.
• - Depoits more than two years in maturity
• Rates on market instruments such as CP, CD and
• corporate bonds were deregulated.

In a practical sense, this is the first interest
rates liberalization attempt. But this ended in
failure.
7

• Rates on financial products whose dividends are
• performance-based including money-in-trust
  and
• beneficial certificates were deregulated.

• The liberalization ratio at that time rose
• greatly as follows
• - 87 in loans, 34 in deposits

8

• Economic background of interest rates
• liberalization in Dec. 1988
• Favorable combination of high economic growth,
• low inflation, a sizable current account
  surplus
• During the three years (1986-1988)
• - Economic growth rate 10.8(annual average)
• - Consumer price inflation rate 4.3(annual
  average)
• - Current account surlus accumulated 24.3
  billion

9

• The reasons of failure in interest rates
• liberalization undertaken in Dec. 1988
• Korean economy had already been moving into a
• cyclic downturn from early 1988.
• Market interest rates rose and some of the
  newly
• liberalized lending rates also showed
  upward
• movement.
• As a result, controls over the liberalized
  interest rates
• were reintroduced.

10

• Liberalization from 1991 to 1997
• Lessons from liberalization in 1988
• Necessity of step by step implementation
• Upward movement of interest rates should be
• minimized after liberalization.
• Liberalization measures should be carried out by
• giving full consideration to the phases of
• price movements and business cycle.

With this, Korea had liberalized all lending
and deposit rates apart from those on demand
deposits.
11

• The basic principles for liberalization at that
  time
• Market interest rates were to be liberalized at
  an
• early stage.
• Lending rates were to be liberalized at a
  relatively
• rapid pace compared with deposit rates.
• The sequencing of deposit rate liberalization was
  
• long-term before short-term, and high
  denomination
• products before low denomination products.

12

• Four stage plan during 6 years
• The first stage (Nov. 1991)
• Liberalization on the loan side
• - Short-term lending rates such as
  overdraft loans
• - Commercial paper discounts
• Liberalization on the deposit side
• - Short-term high denomination
  market deposit
• instruments such as CD, CP, RP
• - Long-term time deposits with a
  maturity of at least
• three years

13

• The second stage (Dec. 1993)
• - All lending rates were liberalized apart
  from loans
• financed by government or by the Bank of
  Korea's
• rediscount facility.
• - Time deposits rate with a maturity of over
  two years
• were liberalized.
• - The rates on corporate bonds with a
  maturity of less
• than two years and on all government and
  public bonds
• were freed.

14

• The third stage (Jul. 1994 - Dec. 1995)
• - Lending rates became fully liberalized.
• - All deposit rates other than demand
  deposits were
• liberalized.
• - Minimum maturity of marketable products
  such as CD,
• CP, and RP was shortened from 90 days to 30
  days
• while their minimum denominations were
  lowered.
• The fourth stage (Jul. 1997)
• - The remaining restrictions on minimum
  maturities and
• denominations of short-term marketable
  products were
• abolished in July 1997, except for minimum
  maturities
• of CD and RP sold by banks.

15
Table 1. The liberalization ratio in each stage
(1991-1997)
16
Implementation of capital account liberalization

• 1. Trend of capital market liberalization
• The first wave (1993 - 1997)
• Three-Stage Blueprint (announced in 1993)
• - The Blueprint was the plan for expanding
• progressively foreigners direct
  participation
• in the domestic stock and money market.
• - It was by bilateral negotiation between
  Korea
• and U.S.

17

• The second wave
• Multilateral negotiations connected with the
  launch
• of the WTO.
• - Individual member countries had to submit
  schedules
• of specific commitments.
• The third wave
• The negotiations to meet the preconditions for
  joining
• the OECD.
• - The schedule of liberalization promised to
  the OECD
• and the schedule of specific commitments
  presented
• to the WTO were similar overall.

18

• The fourth wave
• Since the currency crisis in 1997
• - Korea entered into a stand-by
  agreement for the loan
• from the IMF on December 4, 1997, with
  the
• conditionality of structural reforms
  including wide
• and rapid capital account
  liberalization.
• - The gradual approach previously taken
  was abruptly
• abandoned, and a full-scale opening
  conducted.

19

• 2. Capital account liberalization in major
  sectors
• Stock market
• From 1992, foreigners were allowed to invest
  directly
• in stocks within a certain limit.
• - 1992 10 of each companys total stock
• 3 (individual investors)
• - Nov. 1997 26 of each companys total
  stock
• 7 (individual
  investors)
• - Dec. 1997 55 of each companys total
  stock
• 50 (individual
  investors)
• - After May 1998 no ceiling

20

• Bond market
• July 1994
• - non-guaranteed convertible bonds issued
  by small
• and medium-sized enterprises(SMEs)
• June 1997
• - non-guaranteed bonds issued by SMEs
  and non-
• guaranteed convertible bonds issued by
  large
• enterprises

These measures did not attract foreign
investors' attention because of high credit
risks of the SMEs
21

• Full-scale opening of bond markets,
• - If the spread of domestic and international
  interest
• rates narrowed to less than 2 or
  macroeconomic
• stability continued.
• (Government agreed in the membership
  negotiations
• with the OECD)
• However, the currency crisis brought about the
  full-
• scale opening of the bond market by the end
  of 1997.
• Additionally, foreigners became able to purchase
• short-term financial products such as CD and
  CP
• without any restrictions from Feb. 1998.

22

• Foreign Direct Investment FDI
• Before currency crisis
• - Liberalization ratio of FDI had
  already reached
• at 98.
• 1998
• - The Foreign Direct Investment Facilitation
  Act was
• enacted to improve the environments for
  active FDI.

The liberalization of FDI was broad in scope and
rapid in speed, as FDI perceived as less
liable to generate irregular movements than
any other types of investment.
23
How the liberalizations have affected the Korean
economy?

• 1. The effects of interest rate liberalization
• positive aspects
• - It helps the optimal allocation of
  limited funds by
• intrinsic pricing function of
  interest rates.
• - It can foster financial institutions'
  credit screening
• functions.

24

• - It provides the momentum for
  development of
• financial markets.
• - It stimulate financial markets to
  create much value-
• added of its own accord.
• negative aspects
• - After the liberalization, interest
  rates may rise.
• - Growing competition between financial
  institutions
• could force them to adopt high-risk,
  high-return
• patterns of portfolio management.
• - Small scale financial institutions
  might be excluded
• from the market.

25

• Has the credit screening function been enhanced?
• It seems hard to find much evidence that the
  credit
• screening function has been developed.
• - Debt ratios of shaky large companies
  had reached
• astronomical figures.
• - It points to the continuing
  backwardness of financial
• institutions' credit screening
  ability.
• - Proportion of loans purely based on
  creditworthiness
• has been stagnant.

26
Table 2. Loans by types of Security

Unit component ratio,
27

• Have financial markets been diversified and
• developed?
• It is true that Korean financial markets are
  growing and diversifying.
• - The scale of the short-term money
  markets expanded
• more than four times in 1990s.
• Their ratio to nominal GDP rose from 24 percent
  to
• 33 percent.

28

• - The scale of the long-term financial
  market grew up
• more than seven times.
• Its ratio to nominal GDP rose from 28 percent to
  
• 71 percent.
• The interrelationship between short-term and
  long-term
• markets has been growing.

29
Table. 3 Outstanding of financial markets
in Korea
unit billion won,
30
Table 4. Correlation coefficients between market
interest rates
31

• Has the financial industry become strong enough
• to accommodate financial opening?
• Korean financial firms did not show signs of
  enhanced
• competitiveness and strength.
• - The fragility of the Korean financial
  system was the
• root cause of the crisis in 1997.
• Did financial institutions become "risk-takers"?
  
• There are some indications that the risk-taking
  of financial institutions increased in the 1990s.
• - The margin between deposit and lending
  rates showed
• a narrowing trend.

32

• Bank portfolios also changed.
• - The proportion of securities
  investment has been
• rising.
• Did interest rates go up after liberalization?
• Market interest rates showed a subdued trend.
• When deposit rate liberalization was launched,
  market
• interest rates fell or rose a little bit.
• - These movements were due to both
  favorable
• economic conditions at those times
  and flexibility
• in monetary policy.

33
Table 5. Spread between deposit and lending
rates
Unit , p
34
Table 6. The proportion of securities and
loans to total assets (As of
the end of period)

Unit
35
Fig 1. Trend of market interest rate
36

• Was the financial burden of corporate sector
• increased?
• No sign of an upward movement of market interest
  rates was found.
• On the contrary, the average interest rate firms
  paid
• fell from 12.5 to 10.6 during 1990 - 97.
• - But the financial burden stood at 6.4
  in 1997.
• It rose from 5.1 in 1990 due to the increased
• debt-equity ratio.

37

• 2. Impact of the capital account liberalization
• Positive Aspects
• - It supplements domestic savings.
• - It promotes the development of
  financial markets.
• Negative Aspects
• - A large scale capital inflows may
  cause, through a
• lending boom, the overheating of the
  economy and
• asset price bubbles.
• - Also exchange rates, interest rates
  and money
• aggregates may exhibit sharp
  fluctuations.

38

• Foreign direct investment's positive effects
• - FDI created almost the same amount
  of fixed
• investment in Korea.
• - It contributed to improving the
  productivity and
• technology of the corporate sector.
• - It spread advanced and transparent
  management
• culture which values efficiency.

39

• Wider exchange rate fluctuations
• - With the increased capital in- and
  outflows, the
• exchange rate fluctuated much more
  widely.
• Coping with this, Korea adopted the market
• average foreign exchange rate system.
• Korea shifted to a free-floating regime in
  December 1997.
• Predominance of foreign investors over
• domestic stock market
• - Foreign investors predominate stock market.
• - They tend to lead domestic investors.

40
Fig 2. Net inflow of foreigners' stock
investment and stock price index
41

• Instability of the domestic economy with its
• integration into the world economy
• - Capital account liberalization has made
  Korean
• economy more vulnerable and sensitive to
  external
• shocks.
• - The policy environment of Korea is
  becoming more
• and more uncertain.

42

• Nonoccurrence of a lending boom or asset price
• bubble
• - A lending boom did not appear after
  the capital
• account liberalization.
• The Bank of Korea absorbed the excess liquidity
• created by capital inflows.
• - In the asset markets, Korea did not
  experience a
• bubble due to financial
  liberalization.
• Stock prices are assessed as reflecting real
• economic fundamentals.
• The property markets have shown settled
• movements.

43

• 3. Relation of interest rate and capital account
  
• liberalization to the currency crisis of
  1997
• Interest rate liberalization and the currency
  crisis
• Possiblity
• - Interest rate liberalization leads to a
  financial crisis
• when there is excessive risk-taking by
  financial firms
• Real effects
• - There is no clear evidence that it
  heightened risk-taking
• behaviour that can be attributed to
  the crisis.
• - In reality, financial firms maintained
  the similar invest
• patterns.

44

• Capital account liberalization and currency
  crisis
• Admittedly, capital account liberalization had
  much to do with the currency crisis.
• - There were large-scale inflows of foreign
  capital into
• Korea.
• - The main type of capital was not FDI but
  borrowings
• from international financial markets.
• - And among them, 52 was short term
  borrowing with
• maturities of less than 1 year.
• - Despite the short-term dominant liability
  structure,
• financial firms' asset portfolio
  consisted of long term
• assets.

45

• - Maturity mismatches made Korean financial
  firms
• extremely vulnerable to internal and
  external shocks.
• - In 1997, several large groups of
  corporations, known as
• chaebol, collapsed under the heavy
  weight of their
• debts.
• - Foreign creditors started to reject
  roll-overs of short-
• term debt, but financial firms could not
  call in their
• long term assets to meet the demand.
• - It was a liquidity problem, and as it
  turned out, also a
• insolvency problem because of the
  large-scale
• accumulation of bad assets and consequent
  big losses.

46

• - Korea was driven on the brink of
  national insolvency,
• and turned to the IMF and the
  international community
• for help.
• The main reason of short term borrowings
• - Korean government kept the restriction
  on long term
• borrowing.
• - National sentiment in Korea was not so
  favorable to
• external debt.
• - Most of banks have low credit ratings
  in the
• international financial markets.

47
Lessons to be learned

• From interest rate liberalization
• The authorities as well as financial institutions
  should
• have a resolution to practically settle down
  the
• liberalization measures.
• Interest rate liberalization is best carried out
  gradually
• over the medium term.
• - sweeping liberalization carries the
  risk of failure

48

• It would be unavoidable for the interest
  liberalization to
• be implemented under some uncertainty.
• Some of the side effects should be dealt with in
  the short run.
• From capital account liberalization
• Banks should make efforts to undertake
  international businesses.
• Government should foster prudential supervision.
• - It should devote high-quality
  resources, including
• manpower and budget allocations.
• - Also, the prudential regulation of
  foreign currency assets
• and liabilities should be developed.

49

• It is desirable to provide substantial incentives
  to
• induce FDI.
• It would be desirable to open bond markets a
  little
• faster.
• After full market opening, it is more likely that
• "external forces will trigger a big problem.
• So, it is necessary for government to establish a
• capacity to absorb various shocks.
• - That can be achieved by pursuing
  macroeconomic
• stability, the deepening of financial
  structures,
• strengthening of corporate
  competitiveness.