How to Respond to Surging Foreign Capital Inflow

Capital flows resembles what a living organism does. As any living organism moves to feed itself following its basic instinct, capital flows constantly moves to any capital market in the world for a better expected return in order to maximize the proceeds from investment. It is simple economics that capital always flows into the market that offers higher yield. Evidently continuous capital inflows cause to weaken its currency against the currency of targeted market.

In order to arise from the still on-going economic recession, most advanced countries, United States and some countries of European Union, take all their possible measure to get out of this dark tunnel of gloomy economy. Sustaining zero policy rates and more expansionary easing by issuing federal government bonds are being implemented. However, it triggers significant increases of cash flow and this abundant liquidity seeks higher yield market for a better expected return. That’s how the emerging market became a darling to the world capital market. Currently capital flows surge into emerging-market countries considered as having strong macroeconomic policy and sound financial fundamentals. As mentioned above, simply interest differential due to applying nearly zero interest rates in advanced countries can be an initial factor of this recent trend.  However, in terms of investment perspectives, investors began to shift their focus on emerging market from advanced economies after witnessing the vulnerability of the United States from the financial crisis and also perceived the economic fundamentals as sound and strong in emerging market. According to the article from the New York Times, ‘Buy American? Upscale Investors look abroad’, more wealthy investors are interested in emerging market, South Korea and Brazil, in order to diversify their portfolios since they learned that the United States and other advanced economies are not immune to devastating financial crashes. As one of targeted capital market, Korea has experienced a tsunami of foreign capital, portfolio equity, and fixed-income investments. First of all, this rapid capital flow might cause a distortion of equity market and threaten the stability of the financial system. On November 11, KOSPI index experienced a sudden nosedive by 2.70% day-to-day basis due to the large amount of program selling by foreign investors. It costs fairly large amount of damage to Korean financial market and government officials are in scrutiny.  Secondly, Korean currency is being substantially revalued against the dollars as the supply of dollar soared, raising a suspicion that the Korean won would be overly appreciated over dollars soon which weaken the net export from Korean companies.

Meanwhile, in order to curb or hedge the recent surge of foreign capital inflow, Korean government is considering various measures from a “Tobin” tax on foreign exchange transactions, a tax on capital flows, further limits on derivative positions and, most controversially, the reintroduction of a 14 per cent withholding tax on foreign bondholders’ earnings. As long as it does not cause any significant conflict and unease from foreign investors, it is believed to be effective to control capital flows from rapid foreign capital inflows and outflows.  However, in the long term, more effective and permanent measure shall be necessary to control capital flow as long as Korea is positioned as an open-market economy.

Nouriel Roubini, a well-known professor of economics, suggested that seven options to deal with capital inflows that drive up its exchange rates and threaten export led-growth.

First option is do nothing and allow the currency to appreciate. It is regarded as a right response as far as this change is based on fundamental factors (a current-account surplus, an undervalued currency, a large and persistent growth differential).  However, practically each government systemically intervene the foreign exchange market not to allow the currency to move uncontrollably. Second option is unsterilized foreign exchange intervention. Basically the government absorbs any excessive capital inflow by purchasing dollars, at the same time, more liquidity becomes available as KRW denominated. But that will cause inflation and lead to excessive credit growth. The third option is sterilized intervention. The government issues monetary stabilization bond to absorb unnecessarily abundant foreign-currency denominated capital, at the same time, drive up the higher interest rate to prevents monetary and credit growth. However, keeping interest rate high will give more attraction to bring foreign capital, which contributes to the problem, not to solve. The fourth option is to impose capital control on inflows or not to impose outflows. It is considered to be effective for short-term ‘hot money’’, but it does not affect the overall amount of capital inflows in long term. Fifth option is to tighten fiscal policy and reduce budget deficits to lower high interest rates which drive capital inflows. Once fundamental economy grows based on sound fiscal policy, consequently it will lead to more capital inflows. Sixth option is , which can be applicable to where a country had carried out partially sterilized intervention to prevent excessive currency revaluation, to reduce the risk of credit and asset bubbles by imposing careful supervision of the financial system. The final option is massive, large-scale, and permanent sterilized intervention or equivalently, the use of sovereign wealth funds or other fiscal-stabilization mechanisms to accumulate the foreign assets needed to compensate for the effects on the currency’s value brought about by long-term inflows. The government needs to be prepared for any risk on liquidity and credit and also get rid of any skepticism on a leak of sovereign wealth and related issues.

Appropriate and effective government intervention on its foreign currency against capital flows shall be necessary. However, any excessive artificial intervention can rather deteriorate the problem than solve it. So long as the fundamental economy is sound enough to endure any its currency appreciation, it should be allowed to rise in gradual basis. However, the recent surging capital inflows to emerging market including Korea can trigger its local currency to appreciate severely and bring about significant damages. Under the circumstance, certainly it should be avoided.

Jin Mok Kim (jinmok.kim@gmail.com)

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