The Effectiveness of Korea's Capital Flow Management System and its Implications on Exchange Rate Policy

Abstract

This paper examines the effectiveness of the three macro-prudential measuresintroduced by the Korean government in 2010 and 2011: (i) introduction of limit for FXforward positions of domestic banks and foreign bank branches, (ii) reintroduction of taxon foreign investors' earnings from Korean government bonds, and (iii) imposition ofmacro-prudential stability levy on non-deposit foreign currency liabilities appeared in bankbalance sheets. The results show that the three measures were not successful: The limits ofFX forward position did not lead to the decrease in foreign borrowings. The reintroductionof the tax did not reduce foreign investments in Korean government bonds. Lastly, the levyon non-deposit foreign currency liabilities did not lower the foreign borrowings from thebanks and did not result in more financing through deposits for banks. The ineffectivenessof the capital flow management system in controling the amount of foreign capital flowsimplies that the system might not be effective in mitigating the pressure on exchange ratecaused by excessive volatility of foreign capital flows.