opening the capital market is that foreign capital inflows contribute to economic growth – not only directly, through capital accumulation, but also indirectly, through the associated benefits of the improvement of financial infrastructure. they expanded from 220 trillion us dollars to 1, 726 trillion us dollars during the period according to international financial statistics of imf. but there are many instances where large capital flows have proved to be something of a double - edged sword. they bring great benefits, but also pose risks and policy dilemmas. here the words of imf managing director dominique strauss - kahn are very apt. last week in shanghai, he warned that “ capital flows can lead to exchange rate overshooting, credit booms, asset price bubbles, and financial instability ”. what then are the risk factors inherent in international capital flows? firstly there is the procyclicality of these flows, and secondly, there is the dilemma countries face in their policy responses to them. pro - cyclicality of capital flows 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. in boom periods, large - scale capital inflows can trigger internal imbalances by driving inflation up and increasing asset prices. at the same time they can cause or worsen external imbalances as well, for example, by widening a current account deficit through currency appreciation. massive surges in capital flows can also increase systemic risk in the financial sector by aggravating maturity and currency mismatches between assets and liabilities of financial institutions. in an economic downturn, or when exuberance turns to “ angst ”, in contrast, foreign capital flows out rapidly. this brings in its train currency depreciation and a sudden drop in foreign reserves. real sector economic activities also slow further, due to balance sheet effects arising from currency depreciation as well as a double drain of liquidity – from both the domestic financial and foreign exchange markets. there was an abrupt and massive outflow of capital after the global financial crisis erupted. the emerging market economies experienced very severe turbulence in financial markets, even though they were not at the epicenter of the financial crisis. the impossible trinity 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. the first option for responding to capital flow volatility may be to use the exchange rate as an automatic stabilizer under a freely - floating regime. allowing the rate to move freely at all times can prevent excessive inflows by dampening appreciation expectations. but the real economy may be unable to adapt to large exchange rate swings within a short period and may be negatively affected. a country may intervene to limit exchange rate volatility or to slow the currency ’ s appreciation. but siphoning off the liquidity injected through sterilization may damage the central bank ’ s balance sheet and attract further inflows by maintaining a gap between domestic and international interest rates. as a last resort, capital controls may also be considered as a few countries have introduced recently. but as a recent imf study notes, decisions on their use should be made very carefully. the distortions and costs capital controls incur must be compared with their benefits, though they may form a useful part of the policy toolkit. 2 experience of capital flows and policy responses of korea in this vein, i would like to look back over korea ’ s experiences with volatile capital flows and policy responses. capital inflows during the early and mid 2000s after korea pulled out of the asian currency crisis of the late 1990s, capital flows shifted back to an increase beginning in the early 2000s, due mainly to foreign portfolio investment rather than direct investment, which is inherently more stable. equity investment led the portfolio inflows in the first half of the last decade. this was encouraged by the prevalent low interest rates in advanced countries, abundant global liquidity, and korea ’ s sound economic fundamentals. between 2006 and 2007, however, bond investment inflows took on a more dominant role than equity investment, greatly helped by the increased arbitrage incentives for bond investment. as a result of these large capital inflows, pressures for the appreciation of the korean won persisted. 3 this coincided with an expansion of private sector credit and a steep run - up in housing prices. in response, beginning in the first half of 2006, the korean