Kim, Kyungsoo

English

Research Papers in Economics

 
Global Financial Crisis and Korean Economy by Kyungsoo Kim
∗ 
 
First of all, I would like to thank to Dr. Janet Yellen and her colleagues at Federal Reserve 
Bank of San Francisco for having me this wonderful opportunity.   
As you know, Korea has been hit most severely by the Global Financial Crisis among Asian 
countries. At first glance, compared with other countries, Korea appeared better placed to 
endure the shock created by the global financial crisis, thanks to the cushion of its substantial 
official reserves, its improved policy framework and its very limited exposure to toxic assets 
originating in western banks. 
However, given the region's large trade volume and its financial integration with the rest of the 
world, investors' views on the Korean economy deteriorated as the global de-leveraging 
intensified and world growth slowed markedly. As a result, an immediate impact was felt in the 
foreign exchange markets as foreigners began to repatriate their funds from the Korean 
financial markets. As of the end of November 2008, the Korean won had depreciated by over 
25.4% in dollar term since the collapse of Lehman Brothers in September, the largest fall 
among major Asian countries except for Turkey. The stock price had collapsed by 27.2% during 
the same period. 
In fact, as Figure 1 shows, even before the collapse of Lehman Brothers Korean foreign 
exchange market conditions had been already deteriorated. The figure shows daily 3 year 
interest rate swap (IRS) and currency swap (CRS) rates. Engaging in a basis swap in which two 
streams of money market floating rates of two different currencies are exchanged potential 
arbitrage opportunity is created such as the difference between IRS and CRS rates.
1 It may 
reflect other risks than exchange risk such as counter-party credit risk, liquidity risk, funding risk, 
etc. Risks reflected in basis swap started to sharply rise in early August 2007 when BNP 
Paribas suspended its fund withdrawal, and in November 2007 and March 2008 when news 
related to the sub-prime mortgage problems surprised the market. 
 
<Figure1> 
                                                      
∗ Deputy Governor, Institute of Monetary and Economic Research, the Bank of Korea. This 
paper should not be reported as representing the views of the Bank of Korea. The views 
expressed here are those of the author, and do not necessarily reflect those of the Bank of 
Korea or the Bank of Korea’s policy.   
 
1  There are many other different ways to capitalize on potential arbitrage profits and as a matter 
of fact, derivatives have been important channel for capital inflows to Korea (Kim and Song 
2009). 
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Owing to the evaporation of global liquidity, foreign currency borrowing conditions for Korean 
banks were severely worsened. The CDS (5-year) premiums on FESF bonds showed marked 
upward trends (9.14, 135bp -> 11.30, 368bp) and CRS rate fell relentlessly. In order to ease 
foreign liquidity squeeze, the BOK supplied a total of 26.6 billion dollars in foreign currency 
liquidity through its Competitive Auction Swap Facility using the official foreign reserves, and 
through its Competitive Auction Loan Facility using the proceeds of its currency swaps with the 
U.S. Federal Reserve. On October 19 the Korean government also guaranteed payment for 
banking sector’s external debt due until the end of June, 2009.   
To strengthen the backstop blocking the risk of the global financial market turmoil, the BOK 
established a 30-billion US dollar swap arrangement with the US FRB on October 30, 2008. On 
December 12, the BOK entered into a 180 billion yuan/38 trillion won swap arrangement with 
the PBC, and at the same time agreed with the BOJ on expanding the ceiling of existing 
won/yen swap arrangement from 3 billion US dollars equivalent to 20 billion dollars. 
In spite of such efforts, de-leverage continued, and the CRS interest rate often fell into 
negative territory in February, March and April 2009. The global financial crisis has opened the 
door to even greater arbitrage opportunity. Figure 1 clearly shows that the foreign exchange 
liquidity conditions have not fully recovered yet.   
Domestic credit spreads on corporate and bank bonds also widened rapidly as the liquidity of 
the domestic money market evaporated. This phenomenon, so-called ‘double drain,’ was 
unprecedented. The Bank of Korea conducted aggressive interest rate policy. It cut the “BOK 
base rate” on six occasions, by 3.25%p overall. It also provided a total of 27.8 trillion won in 
market liquidity – by conducting open market operations, increasing the ceiling of its aggregate 
credit ceiling loan program, making banks a one-off payment of interest on their required 
reserves, and contributing to the Bond Market Stabilization and Bank Recapitalization Funds.   
In addition, 12 securities companies were added to the list of eligible counter-parties for RP 
operations, and bank - and special - bonds were newly added to the list of collateral eligible for open market operations, as part of strengthened efforts to alleviate the credit crunch. 
The Korean economy suffered from global crisis preceded by oil price hikes during the first 
half of 2008. From the second half of 2008, both the Korean export and domestic sector began 
to feel the impact of the decline in international demand, and 4
th quarter annual GDP growth 
rate recorded -5.1%.
2 In January 2009, the IMF revised its forecast for Korean GDP growth 
from a positive 2 percent to a 4 percent contraction. This was among its largest negative 
revisions  for  EMEs.    
The rise in external debt has been a main cause for concern among foreign investors, even 
though the recent increase in debt, since 2006 differed in structure from that in the period right 
before the onset of the East Asian crisis. Major proportion of the increase in debt has been the 
product of bridge financing by domestic banks. They engaged in forward contracts with 
exporters and asset management companies and squared their position through borrowing. 
Furthermore, unlike during the East Asian crisis, a bad loan problem did not exist.           
In particular, the external debts of the banking sector drew much attention.
3 For the whole 
economy, the mismatch between the external assets and debts did not widen, but strong 
asymmetry existed in that foreign assets were concentrated in the monetary authority and 
foreign debts in the banking sector (Table1). That is, the risk was concentrated in the banking 
sector.  
<Table1> External Debt and Asset (period-end, billion USD) 
  2005  2006  2007 2008  II 2008 2009  I 
External  Debt    187.9 260.1 382.2 419.8 381.3 369.3 
(short-term) (65.9)  (113.7)  (160.3) (176.2) (151.1) (148.1) 
Banks  83.4  136.5 194.0 210.5 171.7 161.9 
(short-term)  (51.3)  (96.1)  (134.0) (146.7) (113.0) (103.8) 
External  Asset  308.6 366.7 417.7 422.5 348.2 345.5 
(short-term)  (212.4) (242.8) (266.3) (261.8) (279.6) (278.8) 
Banks  53.0 63.2 76.4 84.5 83.0 77.3 
(short-term) (39.0) (39.9) (45.5) (51.9) (52.4) (47.2) 
   Source:  ECOS,  BOK 
                                                      
2  In response to the crisis, the Korean government conducted an aggressive expansionary 
fiscal policy. According to the IMF and the OECD the ratio of stimulus package over GDP in 
2009 is 3.4% and 4.22% respectively. These numbers are much greater than the G20 and 
OECD averages.   
3  The banking sector is composed of domestic banks and foreign bank branches.  
The fact that risk lay in the banks may not be coincidental. Figure 2 plots the rate of growth of 
banking sector’s external debt percentage and the short-term external asset to short-term 
external debt ratio during 1995.I-2008.IV. There is a negative relationship between these two 
variables, which indicates that when banks accumulate external debt, they tend to rely more on 
short-term debt. Thus, when banks accumulate external debts both the risks of currency 
mismatch and maturities mismatch tend to increase.       
 
<Figure2> 
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Before the global crisis, the banking sector drove leverage and after the Lehman collapse, it 
suffered most from de-leverage. This can be clearly seen from Tables 2 and 3. They present the 
flows of foreign liquidity funds in the pre-crisis and crisis periods, respectively. During 2006.I-
2008.III of the 168 billion dollars flowed into Korea 137.4 billion dollars were funded by the 
banking sector. 68.3 billion dollars were domestically absorbed and the rest were recycled 
through overseas equity investment, FDI, remuneration of foreign equity investment, etc. During 
this period, the monetary authorities were net seller of foreign liquidity.     
 
<Table2> Uses and Sources of FX Liquidity (2006.I-2008.III, bil. USD) 
Uses   Sources   
External 
Asset 
General 
Government  
5.0 External 
Debt 
General 
Government   15.8 
 Banks  33.2    Banks  137.4 
 Other  Sector  15.3    Other  Sector  63.0 
 
Monetary 
Authorities  14.8  
Monetary 
Authorities  21.5 Overseas Equity Investment    68.2 Foreign Equity Investment  -78.2 
Overseas FDI  34.5 Foreign FDI  6.1 
Financial Derivatives  -0.6 Other   5.1 
Other Investment  6.2 Current Account  -2.7 
Other Capital Account  -7.0    
Error and Omissions  -1.5    
Total 168.0 Total  168.0 
        Source: Computed form BOK Monthly Bulletin 
 
Table 3 indicates the sudden stop and reversal of capital flows during the global financial 
crisis. Between 2008.IV-2009.I, 42.8 billion dollars flew out from Korea. Severe de-leveraging 
was concentrated on the banking sector, as it was not able to roll over its short-term debt. Even 
though the Korean government declared a loan guarantee, lenders withdrew 59 billion dollars 
while the banking sector itself recovered 9 billion dollars. The monetary authorities sold 25.2 
billion  dollars  of  reserves.            
 
<Table3> Uses and Sources of FX Liquidity (2008.IV-2009.I, bil. USD) 
Uses   Sources   
External 
Asset 
General 
Government  
-9.1 External 
Debt 
General 
Government  
-5.2 
 Banks  -8.9    Banks  -58.9 
 Other  Sector  -4.0    Other  Sector  2.7 
 
Monetary 
Authorities 
-25.2  
Monetary 
Authorities 
5.3 
Overseas Equity Investment    -8.2 Foreign Equity Investment  -4.0 
Overseas FDI  3.2 Foreign FDI  1.4 
Financial Derivatives  13.9 Other   -0.1 
Other Investment  -1.4 Current Account  16.1 
Other Capital Account  -2.1    
Error and Omissions  -1.3    
Total -42.8 Total  -42.8 
  Source: Computed form BOK Monthly Bulletin 
 
As described above, what Korea experienced throughout this crisis can be summarized as 
the capital inflows problem. Pro-cyclicality generated by capital flows has been a major cause of 
vulnerability for small open economy when the pro-cyclicality causes boom-bust cycles (e.g., 
Kaminsky et al, 2005). Excessive foreign capital inflows lead to current account deficits and 
asset bubbles, increase vulnerability to credit tightening, and often result in sudden stops and 
reversals of financial flows. Since the Eat Asian crisis, the Korean economy has progressed towards closer integration with the global financial markets. Its liberalized capital market has 
invited foreign capital inflows – but this has also enabled foreign investors to unwind their 
positions at the earliest signs of trouble.   
The pro-cyclicality of the banking sector borrowing can be confirmed in Figure 3. It plots the 
growth rates of foreign asset and debt calculated from the banking sector balance sheet during 
1995.III-2009.I. Dots tend to be on the 45 degree line, which implies that once the banking 
sector as a whole increases foreign debt its balance sheet expands and vice versa. Through 
financial intermediation the growth of foreign debts is translated into growth of foreign assets, 
which will push up domestic demand through various channels.             
 
<Figure3> 
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How important is the pro-cyclicality of capital flows originated in the banking sector? Table 4 
lists measures of pro-cyclicality of various components of net capital inflows to Korea. Surely, 
capital flows driven by the banks are the most problematic.   
 
<Table4> Pro-cyclicality of Capital Flows: Korea
 
   1995-97  2000-08 
  
2000-05 2006-08 
Pro-cyclicality
1) 
 
 
Net Capital Inflows
   0.64 0.47 0.12 0.94 
FDI -0.53  0.04  0.13  -0.31 
Equity  0.40 0.18 0.18 0.03 
Bond  0.18 0.24 -0.13 0.70 
Others  0.71 0.33 0.06 0.87 
(Bank) (0.64)  (0.41)  (0.00)  (0.92) 1) Coefficient of correlation with quarterly real GDP growth rate in percent against 
previous year 
 
Korea’s recent experience offers important policy implications. Capital account liberalization in 
small open economies has increased their vulnerabilities to sudden large-scale withdrawals of 
foreign capital, and that is exactly what we have witnessed during the recent crisis. And it should 
be noted that this problem has occurred even in countries with strong financial regulation and 
transparent financial systems, for example, Korea.   
It has been argued that financial globalization makes it possible to enjoy collateral benefits 
such as domestic financial sector development, institutional improvements, better 
macroeconomic policies, etc. And these collateral benefits have been said to result in higher 
growth for the globalizing countries, generally via gains in allocative efficiency. The recent crisis 
has demonstrated, however, that financial globalization can lead to collateral damage in 
emerging market economies as well. Therefore, better management of financial openness in 
emerging market countries is the key issue (CGFS, 2009; Choi and Kim, 2010). 
One could defend oneself from such collateral damage by sufficient reserve accumulation. 
But here the question arises: how sufficient is sufficient? According to Greenspan-Guidotti-
Fischer rule, short-term borrowing abroad by the private sector should be absorbed as foreign 
reserves by the monetary authorities. However, the rule might invite moral hazard problem: 
while profits from borrowing are privatized, hedging of the associated risk is socialized (Rodrik, 
2006).  Consequently, the private sector would like to rely on short-term borrowing even more 
and the monetary authorities must accumulate reserves even further. Furthermore, the moral 
hazard problem exacerbates capital inflows problem.   
Direct regulation on capital flows may be another viable option. However, there is little 
evidence that capital controls are effective in achieving their macroeconomic objectives for 
longer than limited periods. The best solution, in my opinion, is to establish an incentive 
mechanism that can harmonize the individual player’s optimizing activity in a way not to cause a 
deterioration of the system soundness, that is, by internalizing the cost of short-term external 
borrowings. 
  
References  
 
Kaminsky G. L., C. M. Reinhart, and C. A. Végh, 2005. “When It Rains It Pours: Procyclical 
Capital Flows and Macroeconomic Policies”, In NBER Macroeconomic Annual 2004, eds. 
Gertler, and K. Rogoff, Cambridge: The MIT Press, 11-53. 
Kim, Kyungsoo and Chi-Young Song, 2009. “Ch.4 Foreign Exchange Liberalization and Its 
Implications: the case of the Korean Won,” In Global Experiences and Implications for the 
Renminbi, eds. Wensheng Peng and Chang Shu : Palgrave Macmillan.   
Committee on the Global Financial System, "Capital Flows and Emerging Market Economies," 
CGFS Papers No.33, BIS, January 2009. 
Choi, Hyoung-kyu and Kyungsoo Kim, 2010. “Some Salient Issues Raised by the Global 
Financial Crisis,” Asia Pacific Economic Review, forthcoming. 
Rodrik, D. (2006) ‘The Social Cost of Foreign Exchange Reserves’, International Economic 
Journal 20, 253-266. 
 
 

Committee on the Global Financial System, &quot;Capital Flows and Emerging Market Economies,&quot;

Some Salient Issues Raised by the Global Financial Crisis,” Asia Pacific Economic Review,

The Social Cost of Foreign Exchange Reserves’,

Global financial crisis and Korean economy

http://www.frbsf.org/economics/conferences/aepc/2009/09_Kim.pdf

Global financial crisis and Korean economy

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