Choongsoo Kim: Increasing volatility in global capital flows - central
banks' policy response
Speech by Mr Choongsoo Kim, Governor of the Bank of Korea, at the 19th Central Banking
Seminar, Bank of Korea, Seoul, 30 November 2011.
* * *
Greetings
I bid a warm welcome to central bankers one and all participating in the Central Banking
Seminar in 2011. I also would like to express my gratitude to Dr. Hyun Song Shin, Professor
of Economics at Princeton University, who is so generously setting aside his precious time to
favor us with a special lecture.
The Central Banking Seminar, which is being held for the 19th time this year, has contributed
greatly as a forum for the sharing of wide-ranging experiences and know-how, and the
building up of human networks linking the working-level staff of leading central banks. We
look forward to a lively discussion on "Increasing Volatility in Global Capital Flows: Central Banks'
Policy Responses" among the 22 experts from 19 countries gathered here for this seminar.
Concerning this topic, as you are well aware, every country is now striving to set up an
effective framework of macro prudential policy and discussions are well under way on
establishing the related global jurisdiction.
Since the Asian financial crisis did not spread to the core of the global financial system
during the 1990s, the mooted establishment of a "New International Financial Architecture"
did not bear fruit.1 However, I believe that this global crisis will spur on a major advance for
the global economy through the crafting of optimal policy options to tackle the challenge
represented by financial crises.
I would like to take this opportunity to say a few words about the challenges the global
economy is facing from the increasing volatility of capital flows among countries and what
should be central banks' policy responses.
Challenges relating to capital flow volatility
Beset by the euro zone sovereign debt crisis and the aftershocks of the global financial crisis,
the world economy is now shrouded in darkness as it traverses a long and deep trough. We
have no means of seeing where it may come to an end nor yet of knowing what awaits us up
ahead.
The fact that these adversities that go by the name of uncertainty are not being so easily
countered tells us that the post-crisis world economy may have to attain a new economic
paradigm rather than returning to the pre-crisis status quo.
Efforts to attain a new paradigm are being driven forward mainly by the governments and
central banks of major countries by way of various frameworks for international cooperation
such as the G20.
The first challenge ahead is from the imbalances in the real economy that we term "global
imbalances". These are the outcome of the combination of macroeconomic policy failure in
major advanced countries and the savings gluts of emerging market countries. Historically
speaking, most financial crises have been largely attributable to similar imbalances in the
real sector. To put it differently, we should be aware that in all financial crises, there are
underlying real sector crises. Unless we understand this correctly, we may end up with
unintended consequences of having killed the messenger as the first way to deal with the
crisis. There is a broad consensus that, if these global imbalances persist for a long time, the
situation will develop into a global crisis or at least provide fertile soil for it. Opinions,
however, differ as to the train of causation.
On the one hand, long-lasting monetary policy accommodativeness and sustained exchange
rate imbalances are cited as the root cause of the global imbalances. Others single out
structural problems which will not be easily resolved any day soon, including the financial
development gap between advanced countries and emerging market countries. Under the
current international financial system, global imbalances are highly likely to persist2 and,
unless fresh and powerful proposal for their solution are soon put forward, the world
economy may run the risk of lurching once again into a crisis of the global system. Therefore,
it is very important to form a strong and sustainable adjustment mechanism to resolve these
global imbalances.
The next challenge ahead is that, in the course of the transmission of the imbalances in the
real economy to the financial sector, there is the growing likelihood of systemic risk being
spread by a shock suffered by a single financial institution or market as financial
interconnectedness is much greater than in the past. With the rapid deleveraging of financial
institutions following the sub-prime crisis leading to fire sales of assets and the foreign
exchange market turmoil, the US financial markets collapsed in a chain and innocent
bystanders including Korea, despite their sound fundamentals, experienced severe hardships
due to abrupt capital outflows. Consequently, an international consensus has been reached
that policy responses in mitigation are needed, in the case of emerging market countries,
whose capital flow volatility is greater than that of advanced countries.
For the advanced countries, net flow volatility is slight because capital outflows and inflows
are mutually offsetting, despite the high volatility of certain types of capital flows. This is not
the case for emerging countries for whom surges in capital flows are largely unidirectional
with massive capital outflows taking place at the time of a crisis and capital inflows building
up again after a crisis.3
Policy efforts to mitigate capital flow volatility are directed internationally toward expanding
and tightening up global financial safety nets (GFSN) in forms such as currency swaps
between central banks, expansion of the resources for financial support by international
organizations, and the strengthening of regional financial cooperation. At an individual
country level, they focus on strengthening policy responses to capital flows. A wide range of
policy instruments are being tried out in many emerging market countries in the wake of the
global financial crisis.
Measures in response and future tasks
As I pointed out earlier, due to the heightened volatility of emerging market country capital
flows, their central banks are hard put to come up with appropriate policy responses. Since
the overriding priority in policy responses should be placed upon ensuring domestic financial
stability, it is absolutely vital to keep inflation expectations low and stable. To this end,
emerging market countries should implement sound macroeconomic policy as a matter of
urgency.4
At the G20 Finance Ministers and Central Bank Governors' Meeting held in Paris in October,
agreement was reached on coherent conclusions to guide the management of capital flows
and on supporting the development and deepening of their bond markets to help emerging
market countries cope effectively with capital flows.5 Major points on which agreement has
been reached include that while macro-prudential policy autonomy is widely recognized,
capital controls6 should be implemented only temporarily; that emerging market countries'
capital flow management measures and key-currency countries' domestic policies (monetary
policies) should be subject to the IMF's surveillance; and that it is important to call for
emerging market countries to carry out gradual capital liberalization while recognizing the
autonomy of their capital flow management measures.
Our historical experience tells us that there is no one-size-fits-all solution to problems
associated with volatile capital flows. Country-specific circumstances and management
capacities have to be taken into account to come up with a varied policy mix involving foreign
exchange rate adjustment, market intervention, monetary and fiscal policies and capital flow
controls.7
In the medium and long term, economies should consider following a three pronged
approach consistent with individual local circumstances: firstly 1) capacity-building to cope
with volatile capital flows, secondly 2) strengthening macro-prudential regulation, and thirdly
3) enhancing international financial cooperation.8
1) Individual countries' capacity building to cope with volatile capital flows
With growing economic integration, the effects of individual economies' conditions on other
economies are growing, and the importance of each economy's stability has increased
further as a result. With a view to stability, sound macro-economic policies are the first line of
defense in reducing economies' vulnerability to external shocks. Events that might trigger a
crisis should be forestalled preemptively by avoiding a build-up of short-term external debts
and maintaining an appropriate level of foreign reserves. What is more, financial sector
capacity building is important, by for example, expanding the basis for the foreign exchange
market over the medium and long-term, so that surges in capital flows can be absorbed.
2) Strengthening macro-prudential regulation
Sharp surges in capital flows are analyzed as brining about the deepening of systemic risks
in addition to the changes they cause in monetary policy transmission channels. To minimize
their adverse side effects, it might be helpful to look into non-macroeconomic options for
moderating capital flow volumes. The imposition of regulations by an individual economy,
including a Tobin tax, needs to be undertaken with caution, as it can give rise to regulatory
arbitrage and reduce international confidence. Properly-designed and well-implemented
prudential policies may play an effective role in alleviating capital flow pro-cyclicality and
minimizing the policy side effects.
Let me briefly introduce a new macro-prudential measure the Korean government introduced
this August, a Macro-prudential Stability Levy. The main purpose of this measure is to control
the high volatility in the capital market caused by increases in banks' non-core liabilities.
Actually the idea of introducing such an instrument was originated by the seminar paper
written by Professor Hyun Song Shin, who emphasized the importance of controlling the
excessive volatility in the banking sector due to increases in non-core liabilities of the
banking system. That was the way to deal with the pro-cyclical nature of the changes in the
liquidity.
After Korea thought of the necessity of introducing such a macro-prudential measure the first
thing we did was to send government and central bank officials to international organizations
including the IMF and the OECD for consultation, to ensure that the measure is in line with
global norms. Although it is still premature for us to assess its effectiveness, we believe it will
contribute to stabilizing the capital market through reducing highly volatile and excessive
capital movements. The levy is distinguished from the so-called capital control measures
represented by the Tobin tax, in that it does not make any discrimination between residents
and non-residents. The OECD has been analyzing the effects of this measure for the past
several months, and I do hope they will come up with a conclusion to make it a globally
accepted instrument.
3) Enhancing international financial cooperation
Given the current environment of financial globalization and strengthened financial
interconnectedness, it is no longer possible for any individual country to achieve the
expected policy effect on its own, and international financial cooperation is therefore
indispensable. In light of international policy coordination, we need to bear in mind that, if an
individual country pursues domestic economic policies without considering negative
externalities, it is highly likely that the country will fall into a prisoner's dilemma trap and that
the world economy will reach a sub-optimal multi-local equilibrium.
Concluding remarks
Historically, an economic crisis has generally led to a crisis in economics. Before the
outbreak of the recent global financial crisis, neither economists nor economic agencies had
a full understanding of housing market speculation and they were unable to arrive at a
correct prediction of the outcomes resulting from banks' behavior and their competitive
structure.
Although central banks are not free of such criticism, the greatest change since the recent
crisis is that their role and position have been heightened as they have been actively
involved as lenders of last resort in overcoming the crisis. On the other hand, however, the
possibility has also increased that central banks will face a paradox of credibility due to the
conflict between their policy goals of achieving both financial system stability and price
stability. In this regard, central banks, as the guardians of the financial system, are called
upon by society to undertake the task of analyzing and examining macro-prudential policies
and regulations. In line with this trend, the Bank of Korea was given responsibility for
financial stability under revised legislation this August, so that it is now better placed to
exercise its financial stability function more actively.
Hopefully, this seminar will provide an opportunity for central banks from around the world in
the light of their particular economic situation to come up with wide-ranging ideas on how to
cope most effectively with capital flow volatility.