Korea Managing an External Surplus: Monetary and Trade...

Report No.7024-6O

KoreaManaging an External Surplus:Monetary and Trade IssuesJune 30, 1908

Country Department 11Asia Regional Office

FOR OFFICIAL USE ONLY

Document of the World Bank

This document has a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without MMrld Bank authorization.

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CURRENC" EQUVALNTS(as of April 15, 1988)

Currency Unit - WonUS$1 - W 740W 1,000 = US$1.35W1,000,00 US$1,351

GLOSSARY OF ABBRGVIATIONS

BOJ - Bank of JapanBOK - Bank of KoreaCCCN - Customs Cooperation Council NomenclatureCD - Certificate of DepositCMA - Cash Management AccountDFI - Direct Foreign InvestmentDMB - Deposit Honey BankEMS - European Monetary SystemFESB - Foreign Exchange Stabilization BondGDP - Gross Domestic ProductGNP - Gross Natioval ProductKSE - Korea Stock :changeLDC - Less Developed CountryLIBOR - London Inter Bank Offer RateNFA - Multi Fibre AgreementMOF - Ministry of FinanceMSA - Monetary Stabilization AccountMSB - Monetary Stabilization BondNBFI - Non Bank Financial InstitutionNIC - Newly Industrialized CountryNTB - Non Tariff BarrierOECD - Organization for Economic Cooperation and

DevelopmentPFI - Portfolio Foreign InvestmentRCA - Revealed Comparative AdvantageRRR - Required Reserve RatioSMI - Small Medium IndustrySTFC - Short Term Finance CompanyUNCTAD - United Nations Council for Trade and DevelopmentVER - Voluntary Export RestraintVVER - 'Voluntary" Voluntary Export Restraint

FOR oMCL4L USE ONLY

KOREA

MANAGING AN ZXTERNAL SURPLUS: MONETARY AND TRADE ISSUES

Table of Contents

Page No.

EXECUTIIVE S114AY.iEXEUTIE UMHARY ...............................................i

I. RECENT ECONOMIC DEVELOPMENTS AND IMPLICATIONS ................... 1

A. Recent Economic Developments . . 1 B. Evolution of Key Determinants .............................. 9C. Meditm-Term Forecasts .. 13D. Implications of Current Account Surpluses . . 16

II. MONETARY MANAGEMENTs INSTITUTIONAL ISSUES ..................... 19

A. Korea's Monetary System: Structure and Change ............ 19B. Use of Monetary Instruments ............................... 27C. Implications of Changes in System ......................... 35D. Financial Liberalization in Korea's Future ................ 43E. Recommendations for Institutional Reform .................. 45

III. MONETARY MANAGEMENT: SELECTED MACROECONOMIC ISSUES ............ 52

A. Monetary Targeting ....... . 52B. What to Target: Choice of Indicators . . 56C. Macroeconomic Effects of Sterilizati o* . .. 64D. Debt Repayment and Ster'lization .... 71

IV. TRADE IMBALANCESs ECONOMIC CAUSES, POLITICAL CONSEQUENCES ..... 73

V. POLICIES TO MANAGE TRADE FRICTION .............................. 90

A. Pernpectives of Trade Management .. 90B. Exchange Rate Management ......... 93C. Trade Liberalization ... 96D. Other Measures ......................... 102E. Recomuendations ......................... 108

This report is based on information gathered from a mission to Seoulduring June 11-29, 1987. The mission comprised: F. Iqbal (Mission Ch.ef),Y. J. Cho, S. Y. Song (Bank Staff) and P. Petri, T. Cargill (Consultant's).Contributions have also been made by S. W. Nam and F. Giavazzi.

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

List of Table.

Page No.Table l.ls Recent Macro and Trade Developments ............... 2Table 1.2: Changes in External Conditions ....................... 2Table 1.3: Bilateral Trade Balances. 3Table 1.4: Monetary Developments. 4Table 1.5s Wage and Productivity Developments.. 6Table 1.6: Saving and Investments ............ ... ..................... 7Table 1.7: OECD Projections .12Table 1.8s Alternative Medium-Term Projections ...... 15Table 1.9: Liquidity Control Bonds .17

Table 2.1: Evolution of Financial Structure .21Table 2.2: Comparative Interest Rates .... 22Table 2.3: Financial Condition of Banks and STFCs .. 25Table 2.4s Institutions and Instruments .27Table 2.5: Discount Volumes and Monetary Growth .29Table 2.6: Recent Deployment of Monetary Instruments .30Table 2.7: Distribution of the Net Increase in MSBs for 1986 and 1987. .32Table 2.8s Sectoral Allocation of Credits .39Table 2.9s Sources of Borrowing, by Sector .. 41Table 2.10s Sources of Borrowing, by Firm Size and Orientation .42

Table 3.1: Financial Sector Growth . . .54Table 3.2: Monetary Indicators S 7......... . 7Table 3.3: Effectiveness of Alternative Monetary Indicators .59Table 3.4: Money Supply Targets in Korea, 1979-1987 .61Table 3.5s Interest Burden of Sterilization . ....... 69

Table 4.1: Recent Trade Results . . . 75Table 4.2s Areas of Rapid Rxport Growth . ................... 78Table 4.3s Exports by Major Partner . ................... 79Table 4.4: Correlations of Revealed Comparative Advantage

(RCA) Indexes ............................................. 82Table 4.5S Direct Foreign Investment in Korea ...............# ......... 83Table 4.6: NTBs and Tariffs Applied to Imports in Developed Countries..84Table 4.7: Average Protection Faced in Developed Country Markets ....... 85Table 4.8: Direct and Indirect Import Requirements of Different

Types of Final Demand ..................................... 87

Table 5:1: Simulated Effects of Hypothetical Policy Measures ........... 95Table 5.2: Simulation Results of Hypothetical Policies ................. 96Table 5.3: Imports of Newly Liberalized Commodities .. 97Table 5.4: Value of Imports in Categories Subject to Liberalization .... 99Table 5.5: Potential Import Effects of Liberalization ................. 101Table 5.6: Projected Trade Effects of Localization of 370 Items

Identified for Localization Prior to 1987 ................ 104Table 5.7: Investment Implications of Localization of 370 Items

Identified for Localization prior to 1987 ................ 104Table 5.8: Possible Effects of Diversification Program .. . 105Table S.9: Voluntary Export Restraints to the US ..................... . 106

EXECUTIVE SUMMARY

I. The Emerging Macroeconomic Context

1. Korea is currently in the midst of an economic boom whicat differs inone critical respect from previous ep_sodes of rapid economic growth: itfeatures large current account surpluses ($4.5 billion in 1986 and $10 billionin 1987) and a reduction in outstanding external debt (of $2.3 billion in 1986and $7.8 billion in 1987). Should such growth, external sur.pluses and debtdeclines be sustained into the 1990s, Korea will have achieved a remarkabletransformation in the nature of its development financing, a transformationthat would herald important structural changes in the country's external anddomestic economic relationships.

2. The present economic boom and the emergence of an external surpluswer- generated by favorable external conditions, including the sharp declinein _xl prices and international interest rates, and the legacy of strongadjustment measures during recent yeazrp which included a significant improve-ment in external competitiveness. The chances for a continuation of the boomtogether with the external surplus condition appear strong at present. Theexternal environment is expected to remain very supportive: DECD growthrates, woIdA interest rates, oil prices and exchange rates are all expected toremain within a moderate band around 1987 levels over the next few years. Thedomestic policy envi-ronment is also expected to be supportive. Governmentfavors maintaining a trade si-rplus in order to reduce its international debtexposure. It has adopted these goals in the Sixth Plan (being implementedduring 1987-91) and is following a number of policiealdesigned to achievethem.

3. In particular, G5tarnment intends to: (a) continue to reduceout'standing external debt by prepaying some loans and not rolling-over others;guidelines and ceilings for both private and public sector foreign borrowingscontinue to remain restr-ictive; and (b) to implement policies supportive ofachieving average current account surpluses of about $5 billion annuallythrough 1991--a level which, in the Sixth Plan, was considered to besustainable and consistent with the debt reduction target of $2 billion perannum. To achieve these goals, conservative money growth targets are to beset and excess liquidity is to be absorbed through sterilization operations;high real interest rates are to be maintained to keep the domestic savingsrate up and to channel funds to high-return investments; the exchange rate isto be managed flexibly; and the exchange and trade system is to be furtherliberalized.

4. Whether these goals will be attained depends also on some otherfactors whose evolution and likely impact cannot be predicted with precisionbut which are nonetheless relevant. One such factor is the ability of theexisting monetary system of Korea--that is, its monetary institutions,instruments, and practices--to contain the pressures generated by largecurrent account surpluses. AnoLher factor is the necessity of managingbilateral trade relationships with OECD trading partners, and particularty theUS, in such a way as to prevent tte intensification of protectionism againstKorean exports.

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5. The twin tasks of monetary and trade management are already uponKorea. The authorities have been straining to soak up excess liquiditythrough the sale of liquidity control bonds. Interest rates have begun toedge upwards as the supply of such bonds has risen. Inflation rates have alsobegun to rise, partly in response to monetary pressures. The fiscal burden ofsterilization operations is beginning to be felt in the national budget. Atthe same time, the degree of trade friction is rising. The US, in particular,has been putting pressure on Korea to revalue the won as well as take othersteps to reduce its trade surplus. Measures to restrict imports from Korea(among other countries-) and to force it to open its markets further are beingdiscussed in the US Congress. Hardly a month passes without a public airingof the trade "problem" with Korea.

6. In light of these evolving issues, the objectives of this Reportare: to review the dimensions of the monetary and trade management tasksimplied by prospective external surpluses; to evaluate the ability of existinginstitutions and policies to cope with the challenges presented by theemerging muacroeconomic situation; and to assess the opportunities provided bythis context for efficiency-enhancing reforms. it is also relevant to empha-size what this Report does not attempt to do. It does not attempt to assessthe overall desirability of external surpluses at this stage of Korea'sdevelopment or to evaluate or choose among the many macroeconomic options thatmay be available to manage such surpluses. The focus of this Report is,therefore, not on external surpluses per se, but rather on monetary and tradeissues highlighted by the surplus condition.

II. Monetary Management: Institutional Issues

7. Goals. A monetary system might be evaluated in terms of certaindesirable goals such as efficiency, adaptability and stability. The desira-bility of specific goals may vary over time in view of specific constraintsbut, in the long run, a system that does not facilitate movements towardsthese goals is unlikely to be consistent with steady and sustained economicdevelopment. Thus a good monetary system should promote efficiency by helpingto establish a financial intermediation structure that provides a large choiceset to the end-users of financial services and allows funds to seek theirhighest, competitive rate of return; it should also prove adaptable toexternal and internal shocks, changes in the sources of growth, changes inintersectoral flows of funds, and in global financial integration; finally, itshould promote stability as far as macroeconomic developments are concerned:while considerable debate continues over activist versus nonactivistapproaches to policy, there is a growing recognition that a strategy committedto price stability is the most important contribution the monetary authoritiescan make to steady economic growth.

8. In Korea's case these goals must be pursued in an environment thatis changing in significant ways. In addition to such macroeconomic noveltiesas external surpluses, debt reduction and a positive domestic savings-investment gap, two developments characterize the emerging context formonetary management in Korea: structural change and liberalization in thefinancial sector.

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9. Structural Changes. The Korean monetary sector has experienced twosignificant developments since 1975. First, the share of non-bank financialintermediaries (i.e., NBFIs, comprising chiefly short-term investment andfinance institutions, savings institutions and securities and insurancecompanies) has grown substantially; this segment currently accounts for about60% of the deposits held in the financial system and for about 50% of theloans made. Second, a variety of monetary instruments with varying degrees ofliquidity (e.g., certificates of deposit, cash management ac:ounts) haveentered the system and have grown in popularity as vehicles of savings andfinancial management. A major implication of these developments is that theprocess of monetary controi is likely to have become more difficult andcomplicated. These developments are relevant for a policy aimed at affectingliquidity in the monetary system since the response of some segments of thesystem may not be controllable by the monetary authorities or may not bepredictable with a comfortable degree of accuracy.

10. Liberalization. Government is committed to a program of gradualfinancial liberalization, including greater autonomy to financial interme-diaries to manage their assets and liabilities. In particular, greaterinterest rate flexibility and the elimination of directed credit areenvisioned together with a greater degree of competition from foreign banks,the promotion of the domestic securities market, and greater flexibility withregard to the movement of capital in and out of the corntry. Indeed, aneventual shift to a freely floating exchange rate is not inconceivable. Suchliberalization measures are likely to have significant effects on the scopeand conduct of monetary policy in the future.

11. An idea of the changes to be anticipated may be obtained from theexperience of Japan whose monetary system twenty years ago was similar to thatof Korea's today. In the early 1970s, Japan began to liberalize its financialsector in order to accommodate changes in the flow of funds brought about bythe end of the "high growth period" of the 1950s and 1960s, help its financialinstitutions become more efficient and capable of competing in the inter-national financial system, and to cope with changes in the scale and speed ofcapital flows in and out of the country engendered by its switch to a floatingexchange rate system. Financial liberalization affected the Bank of Japan'smonetary management in several ways. The BOJ increasingly shifted to instru-ments that affected interest rates rather than credit as an intermediatetarget. It de-emphasized direct quantitative controls on bank lending (e.g.,"window guidance") and came to rely more and more on open market operations.In the process of adjusting to liberalization, it has been hampered by thelack of a short-term government security and, to a lesser extent, by thenarrow holding of Government paper.

Recommendations for Institutional Reform

12. A review of the emerging monetary context and an assessment ofKorean monetary institutions, instruments and practices leads to an agenda ofrecommendations which, if adopted, would assist effective monetary manage-ment. While the agenda focuses on improving the flexibility of monetarypolicy, it is important to keep in mind that the recommended changes will alsocontribute to a smoother and more consistent financial liberalization

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process. That is, the majority of recommended policies would facilitateprogress toward an efficient, adaptable, and sound financial system as well asminimize undesirable resource allocation biases of monetary policy. Therecommendations are:

(a) Apply monetary control instruments, especially those affectingreserves, equally to all the important intermediaries andliabilities in the financial system;

(b) Establish an active interbank market with broad participation;

(c) Establish a competitive government securities market;

(d) Use the BOK discount facility exclusively as a monetary controlinstrument and delink it from industrial policy objectives;

(e) Strengthen the role of the BOK as a guarantor of price stability;

(f) Increase the pace of interest rate liberalization.

13. Equal Application of Monetary Control Instruments. There is astrong a priori basis for expecting weakened and uneven monetary control inKorea as a consequence of structural change and liberalization in thefinancial sector. The rapid growth of the NBFI segment means that alreadyover half of the deposits in the system are outside the scope of reserveregulations and almost half of the loans made are neither subject to directcontrols nor controllable through discount operations. At present, only oneinstrument, the open market sale of Monetary Stabilization Bonds (MSBs), isbeing used to control the liquidity of the NBFI segment. Moreover, there isevidence that suggests that monetary restraint applied to banks is oftenpartially offset by expansion generated by some NBFIs.

14. One way for the monetary authority to increase the degree of mone-tary control in the present circumstances would be to extend reserve regula-tions to NBFIs such as short-term finance companies (STFCs) and savingsinstitutions. A complementary measure would be to extend such regulations toall types of deposits held in deposit money banks (DMBs) and the NBFIs notedabove. These measures can be justified on both effectiveness and equitygrounds. Uniform reserve requirements across institutions and deposit-typeseliminate the effect on the money supply of shifts in deposits amonginstitutions and maturities and thereby provide more effective control overthe money supply. Effectiveness of control is also enhanced by bringing alltypes of deposit liabilities under uniform reserve requirements. Furthermore,now that STFC's and savings institutions have become well-established,fairness requires that their regulatory advantages vis-a-vis DMBs be reduced.

15. The present system has its advantages. It is likely that a largeramount of the money supply is being absorbed through the sale of MSB's toNBFIs than would be possible through the use of reasonable RRRs. This isbecause RRRs could not be applied to su.h institutions as insurance companiesand very small mutual credit associations while MSBs are being sold to them.Also, each institution buys a 1 irger amount because the loss associated with

the purchase of MSBs is much smaller than the loss associated with havingRRRs. Given that the effective lending rate is about 16Z this is theopportunity cost of RRRs which currently carry no interest; on the other hand,the opportunity cost of MSBs is about 3% which constitutes the differencebetween the interest rate which is paid by the BOK (about 13%) and the rate atwhich the secondary market will buy the MSB (16%). It is possible thatimposing RRRs on NBFIs could provoke resistance and could revive the curbmarket.

16. Nevertheless, the virtues of the present system could be retained ina system that does not discriminate among type of financial intermediary asmuch as the present one does. For example, both banks and nonbanks could berequired to hold MSBs and both could be required to hold specific reserveratios. The opportunity cost to the primary dealers/buyers/underwriters couldbe lowered by raising the yield on MSBs so that it is closer to the secondarymarket yield. This would raise the cost for government but would betterreflect the social opportunity cost of containing the monetary pressuresgenerated by an external surplus. In fact, this cost provides a signal togovernment/society regardin- the optimality of a given level of externalsurplus. Furthermore, interest rate flexibility is the best way of buildingmoney markets of all kit.Is. To the extent that the purchases of MSBs areinvoluntary at present, no progress is currently being made towards thefostering of efficient open market operations.

17. The Interbank Market. The interbank market is undeveloped andlargely ineffective as a portfolio management tool for Korean banks. It playsessentially no role in the transmission of monetary policy, in sharp contrastto the situation in most developed countries and, in particular, in Japan.The market is presently a short-term call market (15 days maximum maturity)and features limits on who can participate and to what extent they may doso. Thus, for example, NBFIs, which are presently a surplus-liquidity group,are not permitted active participation in this market. Moreover, limits areplaced on the amount that individual participants can supply or obtain. As aresult the market is thin and the call rate is unrepresentative of the truecost of interbank transfers.

18. The lack of a significant interbank market limits the sources ofmarket-based funding available to commercial banks and increases theirdependence on Bank of Korea (BOK) loans. Indeed, it is believed that theincentive for commercial banks to participate in such a market is itselfweakened by the ready availability of BOK loans to cover reserve defici-encies. At any rate this is an unsatisfactory arrangement from a long termefficiency point of view. A well-functioning interbank market would have fourbenefits for flexible monetary policy. First, it would provide an additionalmeans to spread the effects of policy changes widely across the financialsystem rather than have such effects concentrate disproportionately on any onesegment. Second, it would provide an additional source of information to theBOK regarding pressures in the financial system. Third, it would provide aliquid market for participants to manage risk in accordance with individualrisk-bearing abilities. Fourth, if a bill segment were developed in thismarket, it would provide the BOK wiLh an additional open market policy instru-ment. The experience of Japan during the past two decades suggests that even

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in the context of a highly regulated financial system, an interbank marketprovides an important link between policy instruments of the central bank andultimate policy targets.

19. The Report recommends that Government take the following steps toencourage a broad and active interbank market: (i) allow nonbanks toparticipate on the same basis and together with banks; (ii) relax, andeventually lift, limits on the amounts that can be transacted among partici-pants; (iii) allow transactions in maturities longer than the present 15 daymaximum, say up to 90 days as is typical in most developed money markets;(iv) impose effective penalties on banks for being reserve-deficient, therebyencouraging them to make appropriate use of the interbank market; (v) reduceDMB access to BOK credit on preferential terms, and (vi) permit greaterinterest rate flexibility, so that the markrt can be "cleared" by pricemovements as well as by quantity adjustments.

20. Obviously, these measures cannot and should not be adoptedinstantaneously. They should be implemented gradually and in sequence. Themost important prerequisite for the development of genuine interbank marketsis interest rate flexibility. Until such flexibility eliminates the gapbetween the effective interest rates charged by DMBs and NBFIs to a leveljustified by differences in risk and maturity aspects of their respectiveportfolios, relaxing constraints on interbank transactions may lead to anunacceptably large one-way flow of funds from DMBs to NBFIs. *Tnus, interestrate reform should be implemented before other measures are taken to fosteractive and broad interbank markets.

21. Government Securities Market. An active government securitiesmarket with a broad maturity spectrum could assume major importance for thetransmission of monetary policy. It would spread the effects of monetarypolicy actions throughout the financial and real sectors in three re:pects.First, government securities would be widely held by financial and nonfinan-cial sectors ensuring a widespread impact of changes in monetary policy.Second, it would provide .he foundation for general interest rate determina-tion by creating a flexible default-free short-term interest rate. Third,government securities would provide an important secondary reserve asset forfinancial institutions and thus make it easier to them to make portfolioadjustments in the face of changes in BOK policy. They would play a similarbut less important role for other market participants.

22. An active and broad government securities market has not yetdeveloped in Korea primarily because open-market operations have not tradi-tionally been used in Korean monetary policy. Government was not keen in thepast to pay market rates of interest on internal public debt preferring othermeans to achieve its objectives. For example, it preferred to borrow moneydirectly from the BOK (at zero or close-to-zero interest rates) to fin3ncebudget deficits. On other occasions, when there was excessive liquidity inthe economy, Government chose to reduce this not by issuing securities but byusing direct credit controls on banks and/or adjusting reserve requirements.Even when securities were used, they were not actually put on the market butwere "placed" with banks.

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23. Steps taken recently to broaden the base of purchasers and under-writers of open market Government securities are in the right direction.Among further appropriate steps would be the introduction of securitiescovering a wide range of maturities and aimed at a wide range of investors(individuals, banks, NBFIs and institutions) so as to increase the holding ofGovernment paper and avoid saturating portfolios. These securities must beoffered at competitive market-based rates so as to encourage broad-basediolding.

24. Too much should not be expected of open market operations in theshort run. Given the size of Korea's money market relative to its GNP, it isdifficult to imagine that open market operations will be able to absorb theprospective liquidity surplus without leading to intolerably high interestrates. On the other hand, without interest rate flexibility, a governmentsecurities market will not develop. And even with interest rate flexibilityand the removal of regulatory and other impediments, a well-functioning marketwill only develop gradually. In the interim, the monetary authorities willhave to continue to rely on other channels of transmission of monetarypolicy. In the present circumstances an emphasis on reforming therediscounting mechanism may be most appropriate.

25. Re-orientation of Rediscount Policy. The discount window at the BOKplays a dual role as a general monetary policy instrument and as a method toprovide subsidized credit to favored sectors of the economy and maintain theviability of DNBs. In the past, the industrial policy function of rediscountoperations has often prevailed over the monetary function. While this mayhave been necessary upon some occasions and beneficial upon others, main-taining duality of function now appears to be more and more costly fromi. bothindustrial efficiency and monetary control standpoints.

26. Government should consider using the rediscount facility exclusivelyfor monetary control objectives from now on. Over the foreseeable future thiswould mean deploying the rediscount instrument to achieve monetary restraint.The presently comfortable liquidity situation in much of the corporate sectormeans that output and employment will not be severely affected by a reductionof credi . Profitability might be affected but, to the extent that presentdiscount operations confer subsidies on borrowers, curtailing them may not bean undesirable outcome from an efficiency point of view. Indeed, the sharpreduction of export financing credit facilities undertaken this year is a stepin the right direction both from an efficiency point of view and from thepoint of view of reducing the external surplus and thereby reducing therequired level of sterilization.

27. Moreover, progressively delinking discount operations from indus-trial policy objectives would be consistent with Government's intention ofwithdrawing from active intervention in the economy. Of course, a carefulbalance has to be maintained between these desirable outcomes and thecontinuing need to sustain the financial health of commercial banks. It wouldseem, however, that policy makers have erred on the side of excessive concernfor the banking system in the past, with the result that the system has becomeever more dependent. To the extent that the chief impediment to a moreefficient and self-sustaining commercial banking system is the problem of non-

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performing loans, Government should devote increased attention to the searchfor new solutions and not allow it to act as a drag on financial sectordevelopment.

28. Autonomy of Monetary Policy. Evidence strongly suggests thatmonetary authorities can make the greatest contribution to economic stabilitywhen they remain committed to stable and low inflation rates. In addition,the monetary authorities should pursue this goal with minimal distributionaleffects. Should policy-makers decide to direct resources to a specific sectorof economy, tax and expenditure policies are more efficient. There is consid-erable merit in keeping monetary policy and resource allocation policyseparate and distinct.

29. Formal independence of the monetary policy authority from governmentdoes not ensure stable monetary policy. The Federal Reserve System is one ofthe most formally independent central banks in the world; however, it wasunable to provide a stable financial environment during the 1970s in the viewof a number of observers. In contrast, the Bank of Japan (BOJ) is clearlyless independent than the Federal Reserve and yet, has achieved a degree ofmonetary and price stability that compares favorably with any economy in theworld. Thus, formal independence from government is neither a sufficient nora necessary requirement for the monetary authority to provide a stablefinancial environment; therefore, there is little reason to recommend aparticular structure for the BOK. There is, however, considerable room forimproving the independence of Korean monetary policy.

30. The Report offers three suggestions that if Ldopted, would improvethe ability of the BOK to conduct monetary policy in a more flexible andeffective manner. First, government should avoid using monetary policy todirect credit to specific sectors of the economy. Second, government shouldpromote a reorganization of the banking system to improve its financialcondition to relieve the current burden on the BOK to support weak DMBs evenwhen such may not be consistent with price stabilization measures. Third,government should avoid direct loan relationships with the BOK in the eventthat government deficits reemerge in the future. Instead, such deficitsshould be funded by market-interest-based Government securities. This wouldnot only provide the BOK with a larger stock of securities with which toimplement future open-market operations, but would also make explicit thesocial opportunity costs of deficits.

31. Interest Rate Liberalization. The regulated nature of Korea's inte-rest rate structure forces the effects of BOK policy to be reflected primarilyby quantity adjustments rather than price adjustments. A commitment to in-crease the pace of interest rate liberalization would significantly contributeto a more effective monetary policy in two respects. First, lexible interestrates will integrate market segments via arbitrage transactions and hence,monetary policy effects in one market will be rapidly and smoothly transmittedto other markets throughout the financial system. Second, flexible interestrates will permit the effects of monetary policy to occur with smaller changesin interest rates in any specific segment of the financial market. Theseconsiderations are made all the more important by the fact that the interestrate-expenditure channel of monetary policy becomes more important as

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liberalization progresses, as shown for example by recent Japanese experi-ence. Finally, interest rate flexibility would also encourage the developmentof interbank and government securities markets, thereby providing alternativechannels for the transmission of monetary policy.

32. Interest rate liberalization could be conducted in three steps. Inthe first step, interest rates applicable to comparable-maturity andequivalent-risk deposits and loans would be equalized across financialintermediaries. The integration of such interest rates would help stabilizethe structure of the financial system as well as reduce segmentation. Inaddition, it would promote the development of an interbank market. In thesecond step, floors or downside limits on deposit and lending rates should beremoved and only a uniform ceiling should be left in place. Financial inter-mediaries should be set free to establish rate bands in accordance with riskand maturity characteristics of loans and deposits, and with degrees of effi-ciency of individual intermediaries. In the third stage, ceilings on suchinterest rate bands should also be lifted and a full liberalization ofinterest rates achieved. It is clear that there presently exists a uniqueopportunity for Korea to accelerate the interest rate liberalizationprocess: the economy is booming, firms are flush with cash and financialintermediaries are stronger now than at any other time in the last fiveyears. The case for liberalizing interest rates has never been stronger.

III. Monetary Management: Selected Macroeconomic Issues

33. In addition to the institutional issues involved in effectivemonetary management, there are macroeconomic issues pertaining to theconsequences of sterilization and to policies that may be used to modify orachieve desired targets.

Monetary Targeting

34. The Report deals first with the issue of monetary targeting. Giventhat inflation appears to have been substantially controlled and thAt finan-cial innovation may have disrupted the stability of ttge relationship betweenmonetary aggregates and nominal income, it is legitimate to ask whether or notsystematic monetary targeting remains a worthwhile exercise. The Report con-cludes that it does: monetary targeting should be continued in Korea becausepresent and prospective external imbalances could easily disrupt the pricestability that has been achieved in recent years. Targeting also influencespublic expectations and bolsters the credibility of the authorities, factorsthat are important to the maintenance of price stability. The Report notes,however, that Korea's monetary authorities have greater flexibility in thismatter now than they have had historically: with inflation at a low level atpresent, the authorities can afford to set broader target ranges.

Choice of Indicator

35. There are at least two properties that a monetary indicator mustpossess in order to be a suitable candidate for targeting: effectiveness andcontrollability. Effectiveness refers to rhe strength and stability of the

indicator's link to the level of economic activity; there is little point intargeting an aggregate that has only a weak and unpredictable effect on theultimate goal. Controllability refers to the degree to which the aggregatecan be manipulated by instruments under Government control, such as openmarket operations. Typically, these instruments affect other intermediatevariables, such as interest rates, which in turn influence financial inter-mediary, consumer and corporate behavior in ways that alter the level of theaggregate in question. Clearly there is little point in targeting an aggre-gate that is only weakly and unpredictably linked to policy levers.

36. On the basis of statistical and other considerations the Reportconcludes that if controllability is considered most important, then thenarrowest aggregate MC (currency) should be targeted; if effectiveness isjudged more important, then a broader aggregate (M2CD or M2 plus certificatesof deposit) should be preferred. In either case, the presently targetedindicator, M2, is not superior to these alternatives. The Report also notesthat, to the extent both criteria are important, the preferable strategy mightbe to target and monitor both MC and M2CD.

Consequences of Sterilization

37. Efte ive monetary management requires that targets be set andsterilization policy be conducted in such a way as to minimize the disruptionof (a) domestic money markets and (b) government budgetary or fiscalpriorities.

38. Money Market Effects. Domestic money markets may be disrupted ifinterest rates rise to levels that are so high as to have a significantlyadverse affect on domestic investment and output. This could occur if themagnitude of the sterilization requirement is so large that domestic residentscan only be persuaded to purchase additional sterilization bonds by the offerof higher and higher interest rates. Present and prospective sterilizationrequirements in Korea are such as to render this outcome a distinct possi-bility. By the end of 1987, the outstanding stock of all liquidity controlbonds reached 29% of the stock of money (M2). Upward pressure on interestrates is already evident. The rate on the MSB, the principal open-marketliquidity control instrument, has recently been pushed up from 12.3% to 12.8%in the primary market and upto 16% in the secondary market. Purchasers havebeen signalling in other ways also their concern that their portfolios arereaching saturation levels as far as such bonds are concerned.

39. One reason for pressure on domestic interest rates is the existenceof exchange controls which prevent cross-border capital flows from equalizingdomestic and international interest rates. The Report recommends that theauthorities continue to lift controls on capital outflows in a gradual fashionso as to relieve pressure on the domestic money market. The greater thewillingness of Koreans to hold foreign assets, the lesser the extent to whichthe central bank must hold them, and the smaller the impact on domestic moneymarkets.

40. The authorities have already made moves in this direction. Controlson the use of foreign exchange for tourism and other non-commercial purposes

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have been eased. Approval procedures for overseas direct investments havebeen made less cumbersome. Additional measures might include even furtherrelaxation of these controls. In addition, it may be worth allowing Koreanbanks to hold foreign financial assets up to some stipulated maximum. rhiswould not only ease the sterilization burden, it would also bolster thefinancial condition of Korea's banks by enabling them to diversify theirassets and improve their portfolios.

41. Effects on Budget. Fiscal priorities also stand a risk ofdisruption from sustained sterilization because the internal debt-servicingburden could mount to such a level as to significantly affect budgetaryallocations. By the end of 1987 interest payments on outstanding liquiditycontrol bonds will amount to 14% of budget expenditures, up from 11% in1986. The BOK is presently bearing a major part of this burden but itscapacity to continue doing so is limited by its accumulated surplus, a limitthat is reported to have already become binding.

42. The size of the fiscal burden is related to the differential betweendomestic and international interest rates. The interest rates paid by theauthorities on liquidity control bonds are higher than the interest rates theycan earn by investing their foreign exchange holdings in such instruments asUS Treasury Bills. In addition, the authorities stand to lose in the event ofan appreciation of the won. The greater the gap between domestic and inter-national interest rates and the longer it persists, the greater will be theservicing burden, and thus the greater will be the chances of disruption offiscal priorities.

43. The Report suggests two approaches to dealing with the fiscal burdenof sterilization. One is for the central bank to run sterilization operationsby issuing foreign-currency-denominated bonds rather than domestic currencyones. If, because of exchange controls, these are the only foreign financialassets that the private sector can hold, they should sell at a higher pricethan the price at which the central bank can purchase foreign assets in theinternational financial market. Rather than giving rise to an interestburden, this is a case when sterilization yields a net revenue to the centralbank. The reason of course is that the central bank reaps the monopolyprofits associated with being the only agent in the economy that has access tothe international financial market.

44. A second approach would be for Government to utilize the privatiza-tion initiative announced in early 1987 in the service of sterilization.There are plans to divest about $1.25 billion worth of Government-owned equityin a range of enterprises over the next few years. This measure will auto-matically reduce private sector money balances by $1.25 billion as purchaserstrade cash for stocks. Rather than use the resulting revenues to financeadditional expenditures, government could transfer them to a special fund toservice the interest burden associated with sterilization operations. Thiswould have a significant monetary effect as well as assist in reducing thedisruption of fiscal priorities since interest-servicing would no longer haveto be done at the expense of existing budgetary allocations.

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Debt Repayment and Sterilization

45. The possibility remains that the precediLg measures may not besufficient to avoid macroeconomic disruption. In such a case it is worthconsidering policies to reduce the sterilization target directly. This can bedone by using a given current account surplus to repay outstanding foreigndebt or by reducing the size of the current account surplus itself by avariety of trade and exchange rate measures. The latter measures serve morethan a monetary purpose apd are considered in the section on Trade Management.

46. Korea has reduced its outstanding external debt by almost $10billion since 1985 by prepaying some loans and by abstaining from externalrefinancing of others that fell due. It intends to continue using projectedcurrent account surpluses to reduce its external debt by about $2 billion perannum over the next five years. It has even encouraged the private sector toprepay some external loans and be refinanced (in foreign exchange) through theBank of Korea at terms which are considerably more Pttractive than thosecurrently attaching tn new domestic loans. Finally, it has put a freeze onmost public sector foreign borrowing and tightened the guidelines for privatesector foreign borrowing.

47. Debt repayment as a monetary control strategy appears justified inthe short run given the suddenness and scale of the liquidity surplus and theinflationary risk associated with a 12.5X rate of growth of GNP. Indeed,under present conditions, it could be said that debt repayment is playing asimportant a role in monetary control as is sterilization. In the long runperspective, however, debt repayment would require a different justification,based on the costs and returns to investment in Korea versus investmentabroad. If it is perceived that the sterilization burden of prospectiveexternal surpluses will continue to be unsustainable without assistance fromdebt repayment, the desirability of relieving monetary pressures directly byreducing external surpluses should be considered.

IV. Trade Management

48. Aided by favorable developments such as the decline in oil pricesand realignment of exchange rates since 1985, Korea has produced externalsurpluses of $4.5 billion in 1986 and $10 billion in 1987. The surplusimpressively demonstrates the competitiveness of Korea's exports, but it isnow running at a rate well above Government targets. Closely related to thesize of the overall surplus are politically sensitive imbalances with the USand Japan. Korea has initiated various policy actions to manage thoseimbalances, including the introduction of product-specific incentives toswitch sourcing from Japanese to US and local products. To be successful,however, these measures would require extensive Government influence overimport decisions. In general, the imbalances and associated policy responseshighlight the need for a careful re-examination of Korea trade managementstrategy and of the role of Government in the economy.

49. The surplus with the US has risen from about $4 billion in 1985 toabout $10 billion in 1987, partly because of the replacement of Japaneseimports by Korean imports and partly because the demand for imports in the US

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has remained very strong on account of the large fiscal deficit. Thissituation has led to a chorus of complaints from businessmen, politicians andthe US Government about Korea's "unfair" trading practices, to demands forprotection against Korean exports and to pressure on Korea to revalue itsexchange rate and provide more liberalized access to foreign imports.

50. The deficit with Japan rose from about $3 billion in 1985 to $5.4billion in 1986; it is expected to stay at approximately this level in 1987.It has led Korea to pressure Japan for improved access to the Japanese marketas well as to introduce measures to divert import sourcing from Japan. SinceKorean exports have a high content of imports, especially Japanese imports,the deficit with Japan is intrinsically linked to the surplus with the US; inessence, the one drives the other.

51. Causes of Imbalances. Analysis of the causes of these imbalancessuggests that they are attributable more to comparative advantage (and to theUS fiscal situation) than to deliberate policies of asymmetric access. Thereis an inherently better "fit" between Korean export patterns and US importpatterns, and between Korean import patterns and Japanese export patterns,than vice versa. This is reflected in the fact that the comparative-advantagebased shift in the composition of Korea's export bundle towards engineeringproducts-such as machinery, electrical goods and transport equipment-hasbeen accompanied by a shift in exports to the US; at the same time, growingrequirements for advanced engineering components and capital goods has shiftedimports towards Japan which is the dominant supplier of such goods.

52. This aspect of Korea's trade, that is, import dependence on Japanand export dependence on the US, can be confirmed by analysis of the input-output characteristics of the Korean economy and suggests that presentimbalances will be difficult to change because they are closely tied to thestructure of Korean comparative advantage. The trade sector is highlyspecialized especially in input-sourcing; therefore, intervention designed toaffect the volume and partner-composition of imports will be hampered by lowshort-run elasticities of response. And, to the extent that suchspecialization implies a deficit with Japan, it is inevitable that a surplusoccurs with such countries as the US even if the goal were external balance.If the goal is one of maintaining a moderate surplus, the potential imbalancewith the US becomes even greater.

53. Ideally, policies to manage bilateral trade should be unnecessarysince a country's bilateral trade balances have little significance foreconomic welfare but are the byproducts of the comparative advantages of acountry and its trade partners. Nevertheless, in practice, imbalances havegiven rise to increasing political pressures in the triangular trade betweenKorea, Japan and the US, pressures that may lead to heightened protectionismin the US against Korean exports. Trade, especially with the US, is soimportant to Korean macroeconomic performance that the consequences ofintensified protectionism cannot be ignored. Therefore, despite the existenceof a comfortable overall surplus, it is important to tackle the challengeposed by underlying imbalances, especially that with the US.

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Current Trade Policies

54. Korea has adopted a broad range of measures to deal with imbalancesin its trade, some voluntarily and some in response to pressure from affectedtrade partners, especially the US. Since the imbalances exist on both theexport and import fronts, some of these measures are aimed at reducing exportsand increasing imports, while others are aimed at diversifying among importsources. Among the policies recently adopted by Korea are: exchange rateappreciation, import liberalization, import substitution, import sourcediversification and voluntary export restraints.

55. Exchange Rate Appreciation. The appreciation of the won hasprobably been the most prominent policy action undertaken in the last year orso. During 1987, the nominal exchange rate has been adjusted from a level of860 won to the dollar to around 790 won. This nominal appreciation has beenreinforced in real, effective terms by the sizable wage increments obtained byKorean workers as a result of recent labor unrest. On the other hand, some ofthe appreciation has been offset by the further strengthening of the yen vis-a-vis the dollar since the middle of the year. The exchange rate issueremains a cantankerous one; the US remains unsatisfied with the level and paceof adjustment, whereas Korea is concerned about the severity of theconsequences for domestic exporters.

56. The exchange rate is a critical variable for an economy as dependenton trade as Korea's. Variations in the exchange rate can have substantialtffects not just on the overall current account but also, depending on thee..asticities, on its geographical and product composition. These effects areclearly much relevant in view of Korea's trade situation which features both alarge overall surplus and sizable geographic imbalances. From a long-termperspective, however, other effects of exchange rate variation may be asimportant as the effects on the external balance; for example, the effects onsectoral balance and on domestic real consumption growth have a crucialbearing on long-term economic welfare.

57. An undervalued currency could draw more resources into the exportsector than would be warranted under "equilibrium" conditions, thereby settingup more difficult adjustment problems when equilibrium rates are eventuallyestablished. In Korea's case, it is arguable that the substantial effectivedepreciation of the won since mid-1985 has created a pattern of sectoralinvestment incentives that is not fully consistent with the country's dynamiccomparative advantage.

58. In a similar vein it could be argued that the substantial deprecia-tion in 1985-86 has reduced real consumption standards below their desiredlevels. While it is correct to note that consumption has to be restrained forsome time in order to generate savings and surpluses with which to pay backthe external debt, there remains the possibility that Korea is "overadjusting"and that debt reduction and higher consumption may both be possible.

59. Finally it should be noted that the exchange rate can play animportant role in monetary management. Appreciation reduces monetarypressures by reducing incentives for capital inflow into Korea as well as by

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directly reducing the size of the surplus and thereby the magnitude of thesterilization requirement. In addition, by making imports cheaper, itexercises a dampening influence on inflation.

60. Liberalization. The ongoing liberalization program has fourcomponents: continuation of the policy to add importable items to theAutomatic Approval list; lowering of tariffs on selected imports; a decisionto eliminate over a two year period the "surveillance list" of imports whichthreaten an import surget a list that effectively restricts such imports tolow levels; and a decision to review the special laws, based on such consid-erations as health and safety specifications, that threaten to restrict tradeeven for items on automatic approval.

61. In the present context trade liberalization carries seve.al benefitsfor Korea. It enhances economic efficiency and thereby enables a more rapidimprovement in real living standards. It should reduce trade frictions withthe US even if it does not immediately reduce the bilateral trade surplus.And by reducing the overall trade surplus it may defuse pressure for strongermeasures, such as sharp won appreciation, or distortionary measures such asthose designed to shift trade patterns by fiat.

62. Targeted trade liberalization may also have a substantial effect onthe path and pattern of domestic consumptior. It may be argued that realconsumption standards are kept unnecessarily low by import restrictions onconsumption goods. This argument is made particularly relevant by the recentefforts of Korean workers to increase their wages and, by implication, theirconsumption levels. Since raising the real standards of living is an impor-tant objective of the Sixth Plan, it is relevant to consider how strategictrade liberalization may help to achieve such an objective.

63. The liberalization program implemented since 1982, however, has nothad sizable measurable effects so far on the structure and level of Korea'simports. This is partly due to the choice of the items so far liberalized, achoice favoring those items for which competitive domestic substitutes werewell established. It may also be due to the application of high tariffs andspecial laws on items on the automatic approval list. Finally, it may be duein part to the existence of other barriers such as those sometimes posed byactions of domestic producers and retailers, or by other features of thedistribution system which impart a bias against imports. Clearly, as long assuch impediments persist, the positive efficiency and welfare enhancingeffects of liberalization will be slowed. The context in which liberalizationoccurs is critical to its success or failure. Without measures that help toestablish an import-friendly regime, liberalization may only serve to raiseexpectations and may exacerbate trade frictions rather than reduce them ifthose expectations are not met.

64. Import Substitution. This is being accomplished through a"localization" program which seeks to initiate or increase domestic productionof a long list of imported goods. Beside helping to identify items and settargets, Government is offering financial support for "localization" invest-ments. The proximate objective is to reduce imports from Japan, especially inthe machinery, automobile, and electronics sectors.

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65. The scope of the localization program is broad in that a widespectrum of manufactured products are covered. The independent effects of theprogram, however, are likely to be limited for three reasons: (a) a signifi-cant amount of import substitution is bound to occur anyway because of thesubstantial appreciation of the yen; indeed some of this is being facilitatedby the Japanese who are shifting certain production lines to Korea to escapefrom the high yen; (b) some localization is occurring on account of thematuring structure of Korea's industry and the evolving skill-mix of its laborforce and (c) the economy is growing rapidly and the presently-projected scopeof the program will barely amount to 1-2Z of total trade a few years hence.

66. Indeed the localization program is not only modest, it is alsoprobably unnecessary. It works at cross-purposes with other policy initia-tives designed to liberalize trade thereby reducing both the effectiveness andthe credibility of those initiatives. Furthermore, it makes ambiguous theprogram to reduce Government intervention in the economy.

67. Diversification. The reduction of imports from Japan is also beingattempted under a diversification program in which moral suasion and financialincentives are being used to get importers to switch sourcing from Japan tothe US. Lists of items whose sourcing should be diversified have beencirculated to Korean importers and US export groups, and are being used inspecial buying missions dispatched to the US.

68. To the extent that an economic rather than a diplomatic rationaleexists for diversification, it must be that imports from the US are like"infant industries"--that is, suffer from some startup problems due to theunavailability of information, after-sales service, and the like. It isunlikely that a strong case could be built for an across-the-board diversifi-cation program on the basis of such arguments. Furthermore, if the diversifi-cation program is to have a permanent effect it must be accompanied bymeasures to reduce existing imperfections in the domestic distribution system,imperfections that may impart a geographic, non-price bias to import-sourcing.

69. Voluntary Export Restraints. Protectionism imposes tangible costson exporters, some directly and others as a consequence of policies, such asvoluntary export restraints, adopted to avoid it. Two sorts of voluntaryexport restraints are currently being implemented, a regular VER adopted uponnegotiation with or request from importing countries and a "Voluntary" VERimposed on a member of industries even without such negotiations orrequests. The latter type of VERs has been presumably adopted as a pre-emptive measure to buy goodwill from trade partners and defuse potentialcomplaints.

70. In the short run, VVERs represent a quick and certain instrument foralleviating trade friction. In the long run, however, they have complex andfar reaching implications for industrial structure. An effective VVER programwould involve Government in detailed monitoring and intervention in some ofKorea's most important new industries. This makes it a risky policy indeed,for Government will be deciding, in effect, international growth and marketingstrategies at the leading edge of Korean industry. In fact, Governmentinvolvement will itself complicate private decision-making since it will make

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it necessary for firms to adopt strategic policies to try to obtain shares inKorean exports. Firms may even enter industries where they would be otherwiseuncompetitive, for the purpose of reserving future export claims. In thisstrategic context, Government will also suffer from inadequate information,since firms will have a strong incentive to distort information that relatesto their costs and competitiveness.

71. The rapid proliferation of VERs illustrates the difficult tradeoffsthat foreign protectionism imposes on Korean policy. On the one hand,independent private decisions can be suboptimal in the context of contingentforeign protection. On the other, the defensive control of exports can alsolead to serious distortions--Government is not equipped for intricate,strategic decision-making in the international marketing of new and sophis-ticated products. The fact that such serious disadvantages are associatedwith VERs suggests that other, more neutral measures to manage trade should bevigorously pursued and exhausted before VERs are imposed.

Policy Recommendations

72. In the Report the above policies are evaluated and compared inaccordance with three criteria: (a) their desirability on welfare andefficiency enhancing grounds; (b) the4r impact on the overall externalsurplus; and (c) their impact on bilateral trade balances, especially with theUS. Policy rankings with respect to the first criterion are established in aqualitative manner, while those with respect to the other two criteria areestablished by means of a quantitative exercise using input-output data. Theresults may be summarized as follows: partner-neutral policies such as tradeliberalization and currency appreciation are to be preferred on welfare andefficiency grounds; they are also to be preferred if the objective of reducingthe overall surplus is deemed desirable as indeed appears to be the KoreanGovernment's position at present. Analysis also reveals that appreciation ismost effective in reducing trade surpluses with the US; the other policieshave far more modest effects. Moreover, the partner-specific policies, viz.,import substitution, diversification and voluntary export restraints, wouldprobably do more harm than good if they were to be impiemented at the inten-sities required to have a significant effect on bilateral balances. Therecommendations that follow are based on assessments of the scope and conse-quences of each set of policies and reflect the policy rankings justdescribed.

73. Government intervention should focus primarily on the liberalizationof existing trade restrictions. Today's strong current account positionprovides an unprecedented (in Korea) and unusual (in the internationalcontext) opportunity for opening markets. Liberalization efforts elsewherehave failed precisely because of the absence of a supportive macroeconomicenvironment. Korea's strong external position and rapid economic growthprovide an extraordinary opportunity for implementing aggressive liberaliza-tion measures. In particular:

(a) Rapid progress should be made on streamlining and/or eliminatingspecial laws. These laws represent the most opaque and probablyleast desirable element of Korea's present import structure.

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(b) Tariffs and other taxes levied on imported consumer goods should bereduced. Charg s on imports are very high in a number of cate-gories, recent adjustments notwithstanding. Further cuts are neededto raise Korean living standards and improve the efficiency of theeconomy.

(c) An import-friendly regime should be put in place quickly for finalgoods (consumer products and foodstuffs) including adequate accessto credit and distribution channels for firow wishing to import suchitems; entry procedures for new firms to the consumer market shouldbe facilitated.

(d) Liberalization should be targeted to reduce trade imbalances withthe United States. Addressing trade diplomacy problems withliberalization (a trade-increasing solution) is much preferable tothe adoption of (trade- decreasing) alternatives such as voluntaryexport restraints. Unfortunately, prospects for success in thisarea are limited, although there are highly visible areas forreform, such as agriculture.

(e) The surveillance list should be eliminated, as currently planned,and replaced with an open and visible temporary protection schemewhich would provide a safety net for seriously affectedcompanies.

74. Together with trade liberalization, the proper level of the wonexchange rate is critical. After accounting for the effects of tradeliberalization, the won exchange rate should be set at a level that will yieldthe desired overall surplus. The appropriate level of the overall surplus isnot the subject of this study, since the economic considerations in estab-lishing these targets are in part dominated by political considerations.However, given the difference between the emerging current account surplus(now approaching 8% of GDP) and government targets, an effective liberaliza-tion program will be needed. If the effects of liberalization fall short ofreducing the surplus to desired levels, the exchange rate may be the primarypolicy tool available to Government. Of course, since this tool is typicallyvery powerful, it should be used with the appropriate caution, much as isbeing displayed in the present conduct of exchange rate policy. ShouldGovernment decide, after considering wage rate and other developments, thatsome further won appreciation is appropriate, its effects could include thefollowing:

(a) The overall surplus could be reduced thereby reducing frictions withaffected trading partners and diminishing prospects for intensifiedprotectionism.

(b) The bilateral trade surplus with the US could be significantlyreduced with very favorable implications for Korean tradediplomacy.

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(c) Macroeconomic stresses such as inflation could be reduced withoutadopting much more complicated and interventionist microeconomicpolicies.

(d) Excessive investments and serious future adjustment problems inindustries that are not competitive at equilibrium exchange ratescan be avoided.

15. To the extent that direct microeconomic policies are needed tomanage trade conflict, private responses should be stressed rather than publicones. Firms that perceive threats to their export markets will seek tominimize such threats through public relations, joint ventures, and defensiveinvestments. These responses may be costly, but they are likely to be bettertailored to actual threats than broader Government actions. To this end,Government should:

(a) Permit and encourage firms to experiment with alternative approachesto warding off protection, including investment in foreign assemblyfacilities and marketing joint ventures with foreign firms.

76. If Government microeconomic intervention becomes necessary, neutralmeasures should be stressed rather than product-specific measures. Economictheory argues for interventions that directly address the source of aparticular externality and introduce the minimal additional distortions. If areduction in the bilateral surplus with the US is required, the idealanalytical solution will approximate the effects of a uniform subsidy onimports from the US and a similar tax on exports to the US. An actual tax-based approach is unlikely to be implemented but it does provide a standardfor evaluating other policies. Product-specific departures from a neutralnorm need to be justified clearly with reference to factors peculiar to theproduct. In keeping with these criteria:

(a) Voluntary VERs should be used with great caution. Self-imposedexport restraints impact Korea's most rapidly growing exports--thatis, commodities in which Korea has a strong competitive position andis developing major world market shares. For various reasons, it isextremely risky to manage Korea's trade balance by controllinghighly promising exports. At the same time, it is clear that aneffort to reduce bilateral trade imbalances should include policiesthat affect the export aide as well as the import side.

(b) The localization program should be re-examined critically. Supportof localization involves Government in a wide range of explicitdecisions about import-substitution. Most objectives of the programare likely to be accomplished anyway due to the appreciation of theyen, and the existence of the program complicates Korea's positionin trade negotiations.

(c) The diversification program should be used only as a last resort.To the extent that diversification involves the distribution ofinformation at home and abroad about potential sales opportunities,it should be vigorously pursued. However, significant import

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switching through this program would require very costly financialincentives. The program also exacerbates trade tensions. Despitethese drawbacks, however, the diversification program is the mostneutral of the direct intervention efforts that are currently beingpursued, since it covers nearly all Korean imports.

77. As these recommendations show, there is considerable opportunity forstreamlining the mix of policies with analytical priorities. At present, toomuch of the trade management effort is concentrated on microeconomic interven-tions, and too much of this effort is focused on individual commodities. Thisis the case with the three most visible programs that have been implemented:localization, diversification, and voluntary VERs. These programs work atcross-purposes with Korea's general trade-opening strategy and confuse foreignperceptions about the Korean liberalization effort. They have the unfortunateeffect of diluting the credit that Korea deserves for having taken somecourageous steps with regard to liberalization and appreciation.

78. A more pronounced orientation toward effective and neutralinstruments is clearly warranted. In recommending this, it is recognized thattrade diplomacy imposes constraints not only on actual policy but also onGovernment's public communications. It is possible, for example, thatproduct-detailed policy announcements have greater credibility both at homeand abroad than neutral exchange rate changes. This can partly justify theattention focused on detailed action programs in the past. Yet the underlyingproblems will not disappear on their own and need to be addressed with realsolutions. The sooner these solutions are implemented, the fewer Koreanresources will be invested into industries and activities that are not viableunder equilibrium conditions. Korea has an unprecedented opportunity to openits markets, solve its trade conflicts, and begin reaping the benefits thatits recent successes make possible.

I. RECENT ECONOMIC DEVELOPMENTS AND IMPLICATIONS

A. Recent Economic Developments

1.1 Current Account Surplus. The most prominent macroeconomic develop-ment since 1985 has been the emergence of surpluses on the current accountsimultaneously with rapid (double-digit) economic growth (see Table 1.1).During 1986 the external surplus totaled US$4.6 billion, most of it achievedin the second half of the year. A similar surplus has already been achievedin the first half of 1987 and it is expected that this year's surplus willeventually total about $10 billion. Simultaneously with these surpluses,Korea is reducing its external indebtedness, by about $2.3 billion in 1986 and$7.5 billion in 1987. Should such growth, surpluses and debt declines besustained into the 1990s, Korea will have achieved a remarkable transformationfrom a high growth/high debt economy to a high growth/low debt economy. Thus1986 and 1987 may prove in retrospect to be watershed years during which asharp break was accomplished in the nature of Korea's development financing.

1.2 It is instructive, therefore, to examine the causes of Korea'ssurpluses. Four factors are prominent in any current discussion of Korea'sexternal performance: oil prices, exchange rates, international intereetrates, and OECD economic growth. During 1986, all of these factors contri-buted positively towards Korea's current account surplus but the first twofactors were by far the most important. Lower oil prices accounted for almost50Z of the improvement and exchange rate realignments, in particular, thesharp appreciation of the yen relative to the dollar and won, accounted foralmost 40% (see go, 1987). During 1987, however, the balance of causes haschanged considerably. Both oil prices and international interest rates haverisen (see Table 1.2) and are therefore expected to have an adverse e,fect onthe current account. Exchange rate realignments (since 1986) have beenmixed. On the one hand, the yen has continued to strengthen against thedollar. On the other, the won has also appreciated against the dollar. Onbalance, however, the won has continued to depreciate, albeit modestly,against the yen and this should have a positive effect on the currentaccount. The strongest positive forces now in play may be the lagged andcurrent effects of won depreciation against the yer..

1.3 Another aspect of the current account situation that is worth notingis the severe underlying regional imbalance. The surpLus in 1986 was the netresult of a large deficit with Japan and an even larger surplus with the US(see Table 1.3). A similar tendency can be observed in the 1987 data. Korearemains dependent on Japan for critical capital goods imports which havedisplayed a stubborn inelasticity to the value of the yen. Thus, as the yenhas soared, so has Korea's bill for imports from Japan.

Table 1.1: RECENT MACRO AND TRADE DEVELOPMENTS(in billions of dollars)

1985 1986 1987 /a

Current-account balance -0.9 4.6 10.0Trade balance 0 4.2 7.0Exports 26.4 33.9 44.0Imports 26.4 29.7 37.0Invisible balance -1.5 -0.5 1.5Invisible exports 6.6 8.1 10.5Invisible receipts 8.1 8.7 9.0Transfers (net) 0.6 1.0 1.5

Real GNP growth (Z) 5.4 12.5 12.5GNP deflator growth (Z) 4.0 2.3 4.5External Debt $ 46.8 44.5 37.0

Source: Monthly Statistical Bulletin, Bank of Korea.

/a Projected.

Table 1.2: CHANGES IN EXTERNAL CONDITIONS

1985 1986 1987.9

Crude oil price /a 27 14 19Yen per dollar /b 239 169 141Won per dollar 7i 870 881 824Won per yen 3.6 5.2 5.8LIBOR /c 8.4 6.9 7.9World trade volume /d 3.2 4.9 4c5Export unit value /I -4.2 1.5 2.5Import unit value 7e -3.7 -6.3 1.9OECD growth rate IT 3.0 2.3

/a Average of monthly fob prices in dollars per barrel.7i Annual average for 1985 and 1986; end-September value for 1987.7T Percunt per annual for 3 month LIBOR.7- Rate of change estimates.7e From OECD: Economic Outlook, 1987.

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Table 1.3: BILATERAL TRADE BALANCES(US$ billion)

1985 1986 1987(Jan-June)

ExportsUs 10.8 13.9 8.3

Japan 4.5 5.4 3.5Other 15.0 15.4 9.2

Importsus 6.5 6.5 3.9

Japan 7.5 10.9 6.5Other 17.1 14.2 8.3

Trade Balanceus 4.3 7.4 4.4Japan -3.0 -5.5 -3.0Other -2.1 1.2 0.9


1.4 Monetary Developments. The turnaround in the external account sincemid-1986 has been strongly felt in the monetary sector. As Table 1.4 shows,monetary aggregates such as H2 and M3 have been growing at rates above their1985 levels. The broadest measure of liquidity, M3, is growing especiallyfast. During 1987, it has growr at close to 30%. The monetary effects of thesurplus have also been reflected in the remarkable growth of the Korean stock

market. The KSE index rose from 243 in mid-1986 to 310 in January 1987 andfurther to over 500 by 1988, a growth of more than 100%. Differences in the

growth of value of different stocks reflect the sources of the boom and market

sentiments conceraing its future: export company stocks have done the best by

far, led by sharp gains in textiles, primary metals, and electronics; energy-

dependent stocks such as rubber and chemicals have also done well.

1.5 Domestic interest rates show no sign of softening despite the hugeliquidity inflow from the external sector. Money supply (M2) grew by almost20X in 1987 and is continuing to grow at this rate at present. Yet mostinterest rates have tended to move up since 1986 suggesting that money demand

growth has been and is unusually high, and certainly more than can beexplained by the effect of nominal GNP growth. The average yield ongovernment and public bonds rose from 11.6% in 1986 to 12.4% in 1987 andstands at about 13% now. The yield on corporate bonds, a somewhat moreaccurate measure of market pressure, has risen from 12.8% in 1986 to about13.7% currently. Unregulated interest rates in secondary markets are also

believed to be rising.

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1.6 Several explanations are being advanced for this phenomenon. Themost important would seem to be the availability of high returns in the scockmarket. It is thought that many individuals and firms have borrowed money toinvest in the booming stock market, thereby maintaining pressure on creditdemand and interest rates.

1.7 Another explanation for rising interest rates may be found in thepolicy of restricting conglomerate access to credit. Under presentguidelines, many of the larger conglomerates are restricted from increasingtheir debt exposures beyond levels reached in 1986. It is thought that manyof these firms have tried to maintain debt exposures at the limits set eventhough increased retained earnings in 1986 an(, 1987 would have permitted areduction because they are afraid that they may face even lower limits in thefuture; if they show that they can live with less debt they may be required todo so permanently.

Table 1.4: MONETARY DEVELOPMENTS

1985 1986 1987

Monetary growthM2 15.6 18.6 20.0M3 21.1 26.3 30.0

KSE index 163.4 272.6 525.0

Interest ratesCurb market rate 24.0 23.1 24.0Corporate bond yield 14.2 12,8 13.7Public bond yield 11.0 11.6 12.4Bills discount rate 18.5 16.0-17.5 14.5-16.0Bank lending rate 10.0-11.5 10.0-11.5 10.0-11.5


5

L.8 The rapid growth in money supply since mid-1986 did not seem to havean apparent effect on inflation during 1987 (see Table 1.1). During theperiod 1982-86 inflation declined from 12% to around 4.5%, primarily as aresult of a decline in the import price index (see Corbo and Nam, 1986). Thiseffect was perhaps strongest during 1986, when oil prices fell sharply from$27 per barrel to $14 per barrel. Since oil makes up a large part of Korea'simports, its price has a large effect on overall prices. This has occurreddespite the fact that oil import price reductions are not fully passed throughto domestic consumers. Since January 1987 the price of oil has risen (seeTable 1.2) However, neither this effect nor that of the rising money supplywas translated into a significantly higher rate of inflation during the year.

1.9 For 1988, however, there are troubling indications of risinginf19, this e mnflation as measured by changes in the CPI averaged only 3tin 1987f this figure masks a rate of 5.5b in the final quarter. The trendobserved in the last quarter of 1987 has continued into the first quarter of1988 in which the CPI has risen at almost 7.5%. While much of the CPIincrease in 1987 could be attributed to unusual increases in food pricesfollowing unusually poor weather, the continuation of the trend into 1988 isworrisome by Korean standards.

1.10 Government continues to attempt to moderate price increases bycutting excise taxes and utility rates, reducing import tariffs, and"jawboning" oy consumer goods that are produced under oligopolistic conditionsdomestically.-_ Monetary sterilization is also being continued. During 1987monetary growth was restricted to 20% (for K2) by issuing liquidity controlbonds in the unprecedented amount of 11.5 trillion won (29% of K2). It isunlikely, however, that such measures will be successful in containinginflationary pressures if the external surplus and associated exchange rateand monetary conditions remain largely unchanged from 1987. Import prices,measured in dollars, have risen at an average of 14% in the firss quarter of1988, up from the 11% average for 1987. This trend suggests that recentexchange rate appreciation has not been sufficient to moderate the increase inimport prices arising partly from rising commodity prices and partly from theeffective depreciation of the won relative to the yen.

1.11 There is a concern that even if Korea succeeds in keeping its rateof inflation low it may not succeed in keeping it below that of its chiefcompetitors in export markets partly because Korea alone has experienced asharp increase in wages recently. Already, Korea's inflation rate, while lowin absolute terms, has moved ahead of that of some competitor countries.

1/ Since May 1987, the price of government-held rice has been reduced by10%; electricity charges have been cut by 9.5% on average; the prices ofoil and oil derivatives lowered by about 10.2%; tariffs have been reducedby 5-30% on a large number of items; excise taxes have been reduced on arange of consumer products (such as color TVs and refrigerators) by anaverage of 20% so as to reduce the retail prices of these items by 5-10%.

Korea's wholesale price index rose by 1.1% in the January-August 1987 periodwhile that of Taiwan (China) fell by 4.4Z and that of Japan rose by only0.3%. There remains the concern, moreover, that more labor unrest and wageadjustments are on the horizon.

1.12 Wage Developments. The months of July and August, 1987 saw a rashof strikes and production stoppages by workers pushing for higher wages andimproved benefits. This sudden but sustained wave of labor unrest came on theheels of student-led demonstrations which had succeeded in winning acceptanceof greater political freedoms and culminated, also successfully, in a round ofsubstantial wage increases. It is estimated that the strikes obtained a wageincrease of about 13% for workers in the manufacturing sector. Combined withthe 9% increase that had come about earlier through normal processes, thetotal increase in manufacturing sector wages stood at 22% by the end of thethird quarter of 1987. The unrest has not fully subsided and there is astrong likelihood that further moves towards greater political activity willbe accompanied by greater worker militancy.

Table 1.5: WAGE AND PRODUCTIVITY DEVELOPMENTS(Manufacturing sector)

Korea Taiwan (China)1986 1987 1986 1987

Nominal wage growth 9 22 10 11Productivity growth 8 8 13 13Change in unit labor costs 5 23 4 10

Source: Staff estimates; 1987 figures are projections.

1.13 The prospects for labor stife carry implications for inflation andexport competitiveness. Industrialists have complained that wage increaseshave cut into thin profit margins and will be reflected in higher outputprices. One research institute has calculated that a 10% wage hike (abovemid-year levels) will push production costs up by 2.6% and may reduce exportsby $1.3 billon or 3.5%. While the exact quantitative implications cannot yetbe forecast with much confidence, it is clear that higher costs, decreasedoutput, delayed shipments, and cancelled foreign buyer visits, could erodeKorea's position in the highly competitive market for exports. This is onefactor that will now have to be set against the favorable push provided byexchange rate realignments in 1985-86.

1.14 Productivity calculations suggest a similar threat to competitiveadvantage. During 1986 and 1987, Korean productivity growth has lagged behindthat of several key VIC competitors. Combined with varying exchange rateadjustments and inflation rates, the productivity differential has led to asituation in which unit labor costs have been rising at a faster rate in Korea

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than in some of its competitors. For example, unit labor costs have risen atan average of 14Z in Korea during 1986-87 whereas they have risen at only 8%in Taiwan (China). The major component accounting for this differential in1987 has been the wage rate (see Table 1.5). Finally, it should be noted thatshould such wage adjustments, and the process by which they were achieved,become more than a transitory feature of the Korean economy, the prospects ofhigher inflation caused by cost-push forces will increase.

Table 1.6: SAVING AND INVESTMENT

1985 1986 1987 /a

Gross national saving rate 28.6 32.8 36.0Household 10.6 12.4 14.0Corporate 11.1 13.8 14.5Government 6.9 6.6 7.5

Gross investment rate 31.1 30.2 31.0Fixed investment 30.8 31.3 31.8Changes in stocks 0.3 -1.1 -0.8

/a Projected.

Source: Economic Planning Board.

1.15 Savings and Investment. The savings-investment balance, which isanalytically the mirror image of the current-account balance, reflects thestrong surplus situation of the latter. The gross national savings ratereached 32.8% in 1986, about 2.6 points above the investment rate of 30.2%.It is thought that this rate reached 36% in 1987, a full 5 points above theprojected investment rate of 31%.

1.16 Two aspects of recent savings behavior merit attention. The firstis its high absolute level. At 36%, Korea's savings rate ranks among the veryhighest in the world. It bears repeating that if such a high rate ismaintained for several years there will have occurred a substantialtransformation in the pattern of Korea's development financing, from acondition of chronic indebtedness to a condition of financial self-sufficiencyand capital surplut It also bears noting that with the savings-investmentgap at its current (and prospective) positive level Korea cannot be called acapital-deficient economy and there remains little justification forcontinuing with programs of interest rate control and directed lending. Thisalignment of domestic savings and investment provides the ideal macroeconomicbasis for domestic financial liberalization.

1.17 The second noteworthy aspect, as revealed in Table 1.6, is that thebulk of the increase in the savings rate during 1985-87 has occurred in thecorporate and household sectors; the government savings rate has remained

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virtually unchanged. This reflects the windfall nature of the circumstancesthat led to the increase: a sharp and unexpected turnaround in the externalsituation arising principally from a sudden and substantial realignment ofexchange rAtes in Korea's favor. The household savings rate jumped becausethe transitory, windfall increase in income was put largely into savings. Itis possible that a sustained external surplus situation may lead to a somewhatlower household savings rate (compared to the 1987 level) as householdsreassess the'y permanent income expectations and begin to consumeaccordingly._ Long-term development financing policy should not, therefore,be set on the assumption of a permanent change in household savings behavior.

1.18 The increase in the corporate saving rate bodes well for broader-based financial development. Higher retained earnings could be used to reducecorporate debt burdens. Should a significant number of companies also takeadvantage of attractive stock market conditions to issue equity, the presentsituation could result in desirable strengthening of the stock market as wellas improvement in the corporate financial structure.

1.19 The fact that the governmeut savings rate has hardly moved despitethe dramatic increases in personal and corporate incomes suggests that taxrevenues are not very income elastic. In any case, given the windfall natureof the increase in incomes, it would appear reasonable for government toappropriate a higher level of revenues, possibly by making the tax systembroader as well -s more progressive. Higher appropriations could be used toincrease allocations to social development projects that have long beenpostponed for want of funds. They could also make possible larger budgetsurpluses which could be used in support of monetary stabilization operations.

1.20 Investment. Business attitude surveys reveal considerable optimismwith regard to the future, an optimism reflected in capital spending plans.It is expected that manufacturing sector investment will rise by 29% in 1987and overall investment by 17%. Coming on the heels of a 60% increase ininvestment in 1986, these numbers reveal an enthusiasm undampened by recentincreases in oil prices, domestic wages and the exchange rate. The elec-tronics and transportation equipment sectors continue to be among the topspenders in terms of volume of expected new investment.

1.21 The present enthusiasm may be due to the substantial increases inprofits earned by the Korean corporate sector in 1986 and 1987; by someestimates, profits for large, listed firms have risen by almost 30%. Inaddition, the booming stock market provides a good opportunity for companiesto obtain equity funds at rates which are quite cheap relative to debtfunds. Indeed, many have done so. The average debt-equity ratio of listedfirms stood at about 380 as of June 1987, down almost 40 points from a yearago. Nevertheless, it is worth bearing in mind that sustained labor unrest

2/ Indeed the recent labor unrest is relevant in this regard. It could beviewed as an attempt by workers to break out from a pattern of repressedconsumption and convert some of the national income gains of recent yearsinto direct welfare improvement.

may curb the Korean corporate sector's appetite for more investment in 1988and beyond.

B. Evolution of Key Determinants

1.22 As has been noted in the previous section, the catalysts of Korea'spresent macroeconomic situation have been external. A favorable combinationof low oil prices, a sharply higher yen and above-average growth rates in theOECD countries have propelled Korea's current account into a substantialsurplus and made it possible for it to achieve high growth together with lowinflation. Domestic policies have greatly assisted in the process. A tightmonetary and fiscal stance appears to have reduced inflationary expectationsand to have kept the real exchange rate competitive. Korea's future perfor-mance, in particular the size of its current-account surplus, will depend onthe evolution of these key determinants.

1.23 Exchange Rates. As the yen moved from a level of 220 to the dollarin September 1985 to 160 by mid-1986, Japanese exports became progressivelymore expensive relative to goods from other East Asian countries such asKorea, Taiwan (China), Hong Kong and Singapore. These newly-industrializingcountries (NICs) did not adjust their currencies to rise with the yen; insteadthey largely maintained nominal parity with the dollar, thereby achieving anenormous competitive advantage vis-a-vis Japan. As a result, their exportshave taken a large bite out of Japan's former share in international marketsand especially in the US and Europe. Indeed, since most hard European curren-cies have also appreciated against the dollar since September 1985, the EastAsian NICs have grabbed some of their market share also. At current exchangerates the NICs retain strong competitive advantage in certain products andshould be able to consolidate, and even enlarge, their market shares in theOECD countries. Should the yen or European currencies move even higheragainst the dollar, the export position of the NICs will be strengthened evenmore. The consensus at present seems to be that hard currency exchange rateshave stabilized but that, if they move, they will tend towards further weaken-ing of the dollar. Given this consensus, the outlook for Korean exports looksvery promising.

1.24 Two ongoing developments cast a shadow over export prospects. Thefirst is the continuing pressure by the US on the East Asian NICs, Korea in-cluded, to appreciate their currencies. Under such pressure, Korea has appre-ciated the won by almost 10% in nominal terms since early 1987; however, thepressure has not yet abated and there continues to be a demand that the NICsbear more of a share of the burden of global adjustment (see Balassa andWilliamson, 1987). The second cloud is the possibility of intensified protec-tion. A number of protectionist bills have appeared in the US Congress and,while the most damaging have either failed to pass or have sustained a presi-dential veto, there is a very strong possibility that 1988, an election yearin the US, might well see a pronounced tilt towards greater protectionism. Itis hard to measure the potential adverse impact on Korean exports since thescope and intensity of protectionist legislation is difficult to predict.Korea is attempting to defuse US pressure by appreciating its currency, byfurther liberalizing its imports and by undertaking voluntary exportrestraints for certain products. An additional cautionary factor is the

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prospect of further labor unrest and possibly adverse consequences forproduction costs, output and investment. As already noted, such unrest mayaccompany future political developments. Despite these developments the mostlikely outcome in the foreseeable future is that the enormous competitiveadvantage conferred on Korea by the current configuration of exchange rateswill contiq9e to be reflected in high export growth and large externalsurpluses.-

1.25 Oil Prices. Oil prices have moved back up from the levels hit inthe last quarter of 1986. As already noted, their sharp fall through 1986contributed greatly to Korea's achieving a current-account surplus since theoil import bill constitutes a large part of total imports. The upward movesince then has been expensive for Korea, but this has been more than offset bysurging exports. At present, Korea's import projections are based on oilprices remaining in the $18-20 range. Should they move much higher than this,Korea's external balance will deteriorate. It is, of course, difficult topredict the future price of oil, given the extraordinary circumstances thatpresently surround production and supply from the Middle East. Nevertheless,given the forecast level of demand, given the level of existing petroleumstocks outside the Persian Gulf region, and barring a major cutoff from thatregion, specialists forecast the price to remain in the $18-20 range for1988-90. All other things remaining constant, such a price for oil isconsistent with Korea's achieving an annual surplus of about $5 billion in thecurrent account over the next few years.

1.26 OECD Growth Rates. Exchange rate volatility and the lack ofmonetary policy coordination among the major OECD nations have kept macroeco-nomic forecasters busy revising their estimates. The latest set of estimatesto emerge from the IMF and OECD suggest that industrial-country growth ratesin the period 1987-90 will be somewhat lower than forecast in 1986 (seeTable 1.6). It is now thought that the average OECD growth rate in 1987 and1988 will,t?e 2.3Z with the US growing at about 2.6%, Japan at 2.0% and Germanyat 1.75Z._' These growth rates are considerably below the rates on whichKorea has based its targets for the Sixth Plan period (1987-91). For example,Korea's export growth target of 10% per annum over 1987-91 is based on theassumption that OECD GNP growth rates will average 3.2% and import growthrates will average 4.9%. However, to the extent that the relevant growthrates may be as much as 30% below these assumptions, Korea might experience asubstantially lower rate of growth of demand for its exports. This could

3/ It is also worth noting that the realignment of exchange rates sinceSeptember 1985 has increased Korea's trade deficit with Japan. AsTable 1.3 shows, the export surge to the US has been accompanied by animport surge from Japan, an outcome that highlights Korea's dependence onJapan for capital goods. The extent to which such dependence constrainsand shapes policy measures is examined in Chapter 6 below.

4/ The international stock market crash of mid-October has led to yetanother round of unofficial growth forecast revisions. The forecastspresented in Table 1.6 should probably now be considered optimistic.

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result in a lower rate of CNP growth or a smaller external surplus or both.

1.27 The latest OECD growth estimates are also worrisome on account ofthe fact that they reflect a somewhat higher rate of growth in the US (thanearlier forecast) and considerably lower rates of growth in Japan and WestGermany. This suggests that to maintain its export targets Korea may have torely to an even greater extent on the US market in the next few years than thealready high level of reliance displayed in recent years. This is worrisomebecause such a tendency could exacerbate the trade frictions that alreadyexist between the US and Korea. Furthermore, efforts to shift the burden byincreasing penetration of the Japanese and German markets may encounterstronger resistance than in the past since both economies are expected toexperience rising rates of unemployment and inflation (see Table 1.7).

1.28 The overall effects of slower-than-anticipated growth in the OECDeconomies is ultimately an empirical matter to be resolved by quantitativeanalysis. This is attempted in the following section. Before going on tosuch an analysis, however, the role and orientation of domestic policies needto be briefly mentioned.

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Table 1.7: OECD PROJECTIONS(Seasonally adjusted at annual rates)

1986 1987 1988

Real GNP Z ChangeUS 2.5 2.5 2.75Japan 2.5 2.0 2.0

- West Germany 2.4 1.5 2.0OECD Europe ; 2.5 2.0 2.0Total OECD 2.5 2.25 2.25

Inflation X ChangeUS 2.1 4.0 4.5Japan 0.6 0.0 1.75West Germany -0.4 0.75 1.5OECD Europe 3.7 3.75 3.5Total OECD 2.8 3.5 3.75

Current Accountus -140.6 -147.0 -126.0Japan 86.0 95.0 87.0West Germany 35.8 37.0 29.0OECD Europe 52.0 44.0 23.0Total OECD -19.7 -23.0 -30.0

Jobless in % of Labor ForceuS 7.0 6.75 6.5Japan 2.8 3.0 3.0West Germany 8.0 8.0 8.25OECD Europe 11.0 11.0 11.25Total OECD 8.3 8.25 8.25

Note: Current Account in billions of US dollars.

Source: OECD, Economic Outlook, 1987.

1.29 Domestic Policies. Tight monetary and fiscal policies have beenfollowed since 1982. While money supply has grown at different rates sincethen, these rates have generally been in a conservative proportion to nominalincome growth and associated market conditions. The fiscal deficit has beensteadily decreased as a proportion of GNP since 1982. A generally conserva-tive stance continues to characterize macroeconomic policy in 1986-87 andprojected policy for 1988-90. A rather tight ceiling of 18% is presently inforce with respect to M2 growth and the fiscal account is projected to be insurplus this year. At 10-11, the administered bank lending rates remain highrelative to rates in competitor countries as well as to representativeinternational rates. Such policies support the objective of maintaining high

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CUP growth together with price stability and, by keeping the real effectiveexchange rate competitive, of achieving sustained surpluses on the currentaccount.

C. Medium-Term Forecasts

1.30 In the previous section it has been suggested it is very likely thatKorea will meet its targets for the Sixth Plan with respect to growth, pricestability and external surplus. The analysis so far has been qualitative innature. This section reports on a quantitative analysis of Korea's prospectsbased on a medium-term macroeconometric model--the results confirm theoptimism generated by the qualitative overview.

1.31 The model is initially run using assumptions that reflect ourjudgmeat as to the scenario most likely to unfold with respect to the set ofkey determinants discussed above. The results of this run are reported belowas the Base Case. Since the assumptions are similar to thcse underlying theSixth Plan the Base Case results are, not surprisingly, similar to thoseexpected under the Sixth Plan. The chief assumptions of the Base Case arethat oil prices will rise steadily from $18 to $22 over 1987-91, 3 month LIBORwill hover at 8Z,' OECD imports will increase at about 5% reflecting an OECDGNP growth rate of 3.21 and the won will appreciate by about 2.6Z per annumrelative to the dollar. The results are reported in Table 1.8.

1.32 It is clear from the results that, should the above assumptions holdover the period 1987-91, Korea will enjoy relatively high rates of growth ofreal GNP (7.5%), exports (20%) and imports (9%) while generating currentaccount surpluses of about $6 billion per annum.

1.33 To form an idea of the sensitivity of Korea's prospects to changesin key variables the Base Case is subjected to shocks in the form of alterna-tive assumptions regarding the evolution of these variables. Table 1.8reports results for the following scenarios: (a) an accelerated appreciationof the won by 5% points per annum; (b) lower annual growth of exports of 3%points (c) a combination of the preceding two shocks; (d) an incrementalincrease in oil prices of $2 per barrel; and (e) an increase in wage growth byabout 6% points more than the 9% projected in the Base Case.

1.34 The first scenario could occur if pressure from trade partnerscontinues to mount. The outcome of a gradual nominal appreciation appearsquite manageable from Korea's standpoint. The results show real export growthdeclining and real import growth increasing in response to the steadyappreciation of the won from about 820 per dollar in 1987 to just around 600in 1991. The current account surplus stays roughly constant at around $5 bil-lion in 1988-89 before declining to about $4 billion in 1991. The buoyancy ofthe surplus is due to the operation of J-curve effects--the price increasecompensates for the volume decrease in exports. It may be made morepersistent by the tenacity with which Korean exporters may cling to marketshare, a tenacity reflected in a possible shaving of profit margins, and anemphasis on quality; both of these factors have been observed in US-Japantrade flows since the September 1985 realignment of exchange rates.

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1.35 The second scenario could occur if protectionism increases and/orOECD growth rates are considerably lower than those assumed in the Base Case;in the wake of the mid-October international stock market crash some are evenpredicting the onset of a worldwide recession. Note that under this scenario,annual Korean export growth would decline from about 18% in 1987 to just over5% on average during 1989-91, a fairly substantial reduction to rates belowKorea's historical average and certainly much below those experiencedrecently.

1.36 Despite the severity of the reduction in exports, the currentaccount remains in surplus until 1991. The resistance of the surplus islargely attributable to the fact that Korean imports are a function ofexports: as the latter decline so do the former thereby moderating the effecton the current account. One should expect the resiliency of the currentaccount to be further enhanced by Korea's continuing advance into higher-value-added exports which provide a larger profit margin to work with whenexport volumes are restricted by protectionist action. These factors,together with J-curve effects, appear to explain the persistence of a currentaccount surplus through 1990 even when the two shocks, acceleratedappreciation and lower export growth, occur simultaneously. Thus, even inthis very unfavorable scenario, the surplus condition remains for a few moreyears. 1

1.37 The next scenario, featuring an oil price increase, could occur ifthe politico-military situation in the Middle East took a turn for theworse. The probability of this scenario occuring seems to rise and fall withevery twist and turn of Middle East and OPEC politics. What is noteworthyabout the results is that Korea's external surplus remains in the $4-$8 bil-lion range even as oil prices rise by $2 per barrel per year during 1988-91and even as import growth exceeds export growth by 1988. Once that stage isreached it is likely, of course, that steps will be taken to reduce energyintensity and dependence in much the same fashion as shown by Korea's responseto the 1978-79 oil price shock.

1.38 The final scenario considered is that of an increase in domesticinflation caused by unusually high wage growth or unusually low productivitygrowth or both. The plausibility of this scenario is reinforced by lastautumn's round of labor market unrest and wage increases and the increasedpotential for labor militancy created by Korea's move towards democracy andgreater political activity. Our model links wage and productivitydevelopments to the current account via the wholesale price index, a variablethat affects both exports and imports. The results indicate that wageincreases of about 15% per year (about 6 points above the Base Caseexpectation of 9%) can be accommodated by the economy without seriousconsequences for the current account. Again, such resilience is probably dueto such factors as Korea's continuing move into higher-value-added, less pricesensitive, and less labor intensive exports, and the readiness with which itsexporters may be expected to reduce profits to maintain market share.

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Table 1.8: ALTERNATIVE MEDIUM-TERM PROJECTIONS

1986(Actual) 1987 1988 1989 1990 1991

Sixth Plan Tarsets{i} GNP grovth 12.5 8 8 7 7 7

(ii) X growth (real) 26.6 11 8 7 7 6(iii) M growth (real) 18.6 11 8 8 8 8(iv) Current account (US$ billion) 4.6 5 5 5 5 5

1. Base Case(i} GNP growth 12.5 11 7 7 7 7(ii) X growth (real) 26.6 21 10 8 7 7(iii) M growth (real) 18.6 21 13 8 7 7(iv) Current account (US$ billion) 4.6 10 6 5 5 6

2. Accelerated APPreciation of Won(i} GNP growth 12.5 11 7 7 7 6(ii) X growth (real) 26.6 21 11 6 6 5(iii) M growth (real) 18.6 21 14 7 7 6(iv) Current account (US$ billion) 4.6 10 6 5 5 4

3. Lower Export Growth5i) GNP growth 12.5 11 7 6 6 6

sii) x growth (real) 26.6 18 7 5 4 4(iii) M growth (real) 18.6 21 12 7 7 6(iv) Current account (US$ billion) 4.6 10 4 3 2 0

4. Combination of 2 and 3ti) GNP growth 12.5 11 7 6 6 6sii) X growth 26.6 20 13 6 6 6(iii) M growth 18.6 18 8 3 3 2(iv) Current account (US$ billion) 4.6 10 4 3 1 -1

5. Oil Price Increase(i} GNPgrowth 12.5 11 7 7 7 7(ii) X growth (real) 26.6 20 9 7 7 7(iii) M growth(real) 18.6 20 13 8 7 7(iv) Current account (US$ billion) 4.6 11 8 4 4 5

6. Wage Increaseti) GNP growth 12.5 11 7 7 7 7(ii) X growth (real) 26.6 20 6 5 4 4(iii) M growth (real) 18.6 20 13 7 7 7(iv) Current account (US$ billion) 4.6 10 6 5 5 5

Source: Bank staff estimates; Sixth Plan targets from Economic Planning Board.

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1.39 The remarkable aspect of the results shown in Table 1.8 is thatunder none of these scenarios does Korea's a acroeconomic performance seriouslyfalter. In no case does the rate of growth of real GNP fall below 6x. Thecurrent account turns to a deficit only under the combined shock of anaccelerated appreciation and a sharply lower growth rate of exports due toprotectionism or an OECD recession, and this too not until 1991. Theseresults suggest that the Korean economv is strong and resilient, that itscompetitive advantage is not of a transitory nature nor based narrowly, andthat the momentum it has gained since mid-1986 can see it through a number ofpotential adversities.

D. Implications of Current Account Surpluses

1.40 The current and prospective situation of external surpluses presentsboth opportunities and challenges. As far as opportunities are concerned,surpluses enable Korea to reduce its external indebtedisess, thereby reducingits vulnerability to the vagaries of international finance as well as enhanc-ing its access and creditworthiness. Korea can expect substantially betterterms in international finance markets on its future dealings, terms thatimprove in direct proportion to the diminution of its debt-service and debt-GDP ratios. External surpluses also provide policymakers a margin of flexi-bility especially when they occur simultaneously with high GNP growth. Suchflexibility can prove to be of great help in implementing economic reformssince a lesser degree of sacrifice is necessary than in a situation of lowgrowth and external deficit. Payments surpluses can be thought of asproviding room for maneuver to policymakers as they set about implementingpolicies to reduce remaining distortions in the trade regime and in domesticcapital markets, as well as a cushion for adjustment to economic agents whohave to adapt to the more competitive environment that is implied by suchreform policies.

1.41 Nevertheless, sustained current-account surpluses should not beviewed as an unmitigated blessing. Severe and persistent external imbalancein whichever direction can generate other, less desirable, imbalances both inthe domestic economy and in external trade relations. The domestic imbalancesare typically of a monetary nature. For example, a large external surpluscreates an influx of liquidity into the monetary system which, if unchecked,normally leads to inflation and exchange-rate appreciation. If either ofthese eventual outcomes is considered undesirable, the excess liquidity mustbe soaked up through appropriate monetary operations. Such "sterilization"operations can disrupt domestic money markets, can be expensive to the publicexchequer and may have undesirable resource-allocation and income-distributioneffects.

1.42 The cumulative Korean surplus since mid-1986 has already led to asituation of rapid liquidity inflow whose effects are being countered atpresent by an unprecedented effort at sterilization. Over $6 billion havealready been absorbed by the BOK through the sale of Monetary StabilizationBonds (MSBs); these liabilities carry an interest rate of about 131 and mayultimately become a heavy public sector burden as well as a drag on thedomestic bond market. The value of outstanding national money supply control

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bonds reached 11.5 trillion won by the end of 1987, up 156Z from 4.5 trillionwon at the end of 1986. Of this, about 1 trillion were in the form oftreasury bonds, 9 trillion in MSBs, and 1.5 trillion in Foreign ExchangeStabilization Fund (FESF) bonds. Between the BOK and the Government, anadditional 750 billion won in interest was paid by the end of the year. Thestock of money supply control bonds amounted to 29Z of money supply 042) whilethe interest burden amounted to over 14% of budget expenditures. It should beevident from tg foregoing that, as the surplus grows, so will the cost ofsterilization.)

1.43 Thus one clear implication of emerging external surpluses is thatmonetary management has acquired both policy urgency and prominence. As such,it is important to evaluate overall macroeconomic policy as well as the extentto which the existing monetary system--that is, monetary institutions, instru-ments and practices--is capable of coping with the emerging pressures.

Table 1.9: LIQUIDITY CONTROL BONDS(outstanding stocks, billions of won)

1985 1986 1987

Monetary Stabilizat 1on Bonds 1,900 4,285 9,007

Treasury Bills 0 200 1,000

Foreign Exchange StabilizationFund Bonds 0 0 1,500

Total 1,900 4,485 11,507

Memorandum Items:

Monetary Stabilization AccountBalance 6,518 5,392 3,146

Reserve Deposits of DMBs 735 1,026 2,680Money Stock (M2) 28,565 33,833 4C,280

MSB/M2 (%) 7 13 22Total/M2 (X) 7 13 29

5/ Note, however, that interest paid on MSBs does not come out of thegovernment budget but out of the BOK's surplus.

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1.44 Persistent current-account surpluses also tend to aggravate tradingrelationships, especially with partners who are running the counterpart defi-cits. In Korea's case the chief affected partner is the US, which ispresently putting great pressure on Korea to take steps to curb the size ofits surpluses. The downside risk that Korea runs is that of intensifiedprotectionism. Thus a second implication of continuing external surpluses isthat trade management also acquires urgency and prominence. As such, it isimportant to evaluate the extent to which Korea's trade structure--that is,the composition and geographical distribution of its imports and exports--isresponsive to various policies designed to ease frictions in trade relation-ships.

1.45 The objectives of this report are threefold: to review thedimensions of the monetary and trade management tasks implied by prospectivesurpluses; to evaluate the ability of existing institutions and policies tocope with the challenges presented by such a situation; and to assess theopportunities provided by the external surplus situation for efficiency-enhancing reforms.

1.46 It may also be useful to indicate what this report does not attemptto do. It does not attempt to assess the desirability of external surplusesin a broad macroeconomic context. As such it does not evaluate macroeconomicobjectives and policies other than those directly linked to monetary and trademanagement. This shtould not be construed to mean that the neglected objec-tives and policies are unimportant. Indeed, some may be quite important. Forexample, it would be useful for Korean policymakers to examine the desir-ability of increasing domestic consumption and investment with a view toincreasing the contribution to growth of domestic demand sources or with aview to influencing the distribution of income. Such objectives and some ofthe policies that might be used to achieve them, including cutting taxes,raising government expenditures and permitting higher wage increases, aretreated as lying outside the scope of this report. However, some of thepolicies discussed herein (e.g. won appreciation, import liberalization) havean impact on objectives other than trade and monetary management and, to thisextent, the relevant effects are noted.

1.47 Guide to Report. The remainder of this report is organized as fol-lows. Chapter 2 provides a discussion of Korean monetary institutions andinstruments; of changes in the structure of the monetary system in recentyears and of their implications for monetary control and resource alloca-tion. Factors critical to success in the context of financial liberalizationare identified, and appropriate recommendations are made for effective futuremonetary management. Chapter 3 contains an analysis of the main issues thatarise in the present and anticipated conduct of monetary policy. Among suchissues are the desirability and feasibility of sterilization, the role ofcapital controls, the effectiveness of monetary targeting, and the choice of amonetary indicator. Chapter 4 reviews the causes and consequences of Korea'strade imbalances while Chapter 5 evaluates and ranks policies that have beenadopted, or could be adopted, to cope with the trade situation.

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II. MONETARY MANAGEMENT: INSTITUTIONAL ISSUES

2.1 A monetary system--comprising institutions, instruments andpractices--might usefully be evaluated in terms of certain desirable goalssuch as efficiency, adaptability and stability. The desirability of specificgoals may vary over time in view of specific constraints but, in the long run,a system that does not facilitate movement towards these goals is unlikely tobe consistent with steady and sustained economic development. Thus, a goodmonetary system should promote efficiency by helping to establish a financialintermediation structure that provides a large choice set tc the end-us--s offinancial services and allows funds to seek their highest, competitive rate ofreturn; it should also prove adaptable to external and internal shocks,changes in the sources of growth, changes in intersectoral flows of funds, andin global financial integration; finally, it should promote stability as faras macroeconomic developments are concerned: while considerable debatecontinues over activist versus nonactivist approaches to policy, there is agrowing recognition that a strategy committed to price stability is the mostimportant contribution the monetary authorities can make to steady andsustained economic growth.

2.2 In view of these ultimate goals, the conduct of overall monetarypolicy must be consistent with the following operational requirements:(a) the monetary authority should have access to a set of policy instrumentswhich can be deployed flexibly in the pursuit of stabilization; (b) thetransmission of monetary policy should rely on interest rate and generalportfolio adjustment channels more than on direct credit control mechanisms;(c) the transmission of monetary policy must strive toward an even distri-bution of the effects of monetary policy as the financial environmentincreases in the diversity of institutions and markets; and (d) monetarypolicy should minimize resource allocation biases, especially those thatinsulate unproductive sectors of the economy from the effects of policy.

2.3 An attempt is made in this report to evaluate the Korean monetarysystem in terms of the above-described goals and operational requirements aswell as in reference to the rapidly changing context for monetary policyreflected by the recent shift toward current account surplus, changes in thestructure of the domestic financial system and increased external pressure toaccelerate the pace of financial liberalization.

A. Korea's Monetary System: Structure and Change

2.4 In addition to the central bank, the Bank of Korea (BOK), the Koreanmonetary system is usually described as having two categories of institutions:deposit money banks (DMBs) and nonbank financial institutions (NBFIs). Thedistinction between these two categories is based largely, though not entire-ly, on the fact that NBFIs are not allowed to accept customer deposits. Thecategory of DMBs contains commercial banks and a number of government-ownedspecialized banks distinguished one from the other by the purposes to which

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their lending is statutorily restricted.61 The category of NBFIs is a broadone containing four different types of institutions usually described asdevelopment, savings, investment and insurance institutions. From the pointof view of monetary management, it is useful to distinguish between thedevelopment institutions and the others 7ecause they are subject to far great-er control by the monetary authorities.7 Amcng the others, it is also usefulto separate out the investment institutions, of which the bulk are betterknown as short-term investment and finance companies (STFCs), because they aremost similar to banks and have been growing rapidly. STFCs were recognizedand promoted from 1972 onwards in an effort to broaden the base of the formalfinancial system.

2.5 The last decade and a half has seen enormous changes in the struc-ture of the monetary system as reflected in changes in the shares of differentinstitutions in loans and deposits. The share of DMBs in total loans slippedfrom 682 in 1976 to around 48Z in 1987 (see Table 2.1), while that of NBFIsrose from 32% to 572. Among NBFIs, the share of savings institutions andinvestment companies (primarily STFCs) has risen rapidly. An even more pro-nounced change of structure is shown by the data on deposit shares. Depositmoney banks presently account for only 42% of total deposits, down from 752 in1976 whereas investment companies have garnered a share of almost 302, up fromonly 11% a decade or so ago. These differential rates of growth were causedlargely by differences in regulatory treatment: STFCs have been allowedgreater freedom in asset and liability management and, most importantly, havebeen permitted to apply higher rates on their deposits and loans relative toDMBs. This, one should note, was deemed necessary to attract into the formalsector much of the business previously conducted in the curb market, and

6/ The commercial banks comprise 7 large nationwide banks (also known ascity banks), 10 local banks restricted largely to business in theirregions of origin and 54 foreign banks based largely in Seoul. Thespecialized banks comprise the Korea Exchange Bank, Small and MediumIndustry Baik, Citizens National Bank, Korea Housing Bank and the creditand banking sectors of certain agricultural, fishery and livestockcooperatives.

7/ The composition of the NBFIs is as follows: Development Institutions:Korea Development Bank, Korea Long-Term Credit Bank and Export-ImportBank of Korea; Investment Institutions: Korea Securities FinanceCorporation, 6 Merchant Banks, 32 Investment and Finance Companies and 3Investment Trusts; Savings Institutions: Mutual Savings and FinanceCompanies, Credit Unions, Mutual Credits, Postal Savings and TrustAccounts; Insurance Institutions: 5 life Insurance Companies, DaehanEducational Insurance Company, National Life and Postal Life InsuranceAccounts.

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thereby to promote financial development, greater confidence in te financialsystem and further cultivation of the banking (and saving) habit*-

Table 2.1: EVOLUTION OF FINANCIAL STRUCTURE

Share of Loans (Z) Share of Deposits (2)1976 1984 1987.6 1976 1984 1987.6

Deposit Money Banks 68 51 48 75 53 42Commercial Banks 44 30 29 50 32 24Specialized Banks 24 21 19 25 21 18

INBFIs /a 32 49 52 25 47 58Development Institutions 16 16 16 1 /b /bSavings Institutions 6 11 11 11 14 17Investment Companies 9 16 19 10 24 30Life Insurance Companies 1 6 6 3 9 11

/a For definitions of NBFI categories, see footnote 5._b Negligible.

Source: Financial System in Korea, Bank of Korea.

2.6 Since 1982 the relative regulatory advantages of STFCs have beenreduced. Commercial banks have been allowed to engage in a wider variety offinancial transactions such as dealing in commercial bills and issuing certi-ficates of deposit, transactions previously reserved for the STFCs. Mostimportantly, tne interest rate advantage that STFCs possess has been whittledaway in recent years. Table 2.2 provides information on some representativedeposit and lending rates for DMBs and STFCs and on changes that have occurredsince 1982. In the most recent round of adjustments in May 1987, DMB depositand lending rates were left unchanged while the rate on own bills issued bySTFCs was cut from 82 to 7.5Z and that on commercial paper discounts of STFCswas trimmed from 12Z to 11%. According to the Ministry of Finance, this stepwas taken deliberately to reduce the unbalanced growth of the different

8/ It is relevant to note that the 1980s have been a period of sharplydeclining inflation in Korea, a macroeconomic aspect brought about andsustained to no small extent by tight monetary policy. One consequencehas been the maintenance of relatively high real interest rates andassociated high and rising savings rates. Macroeconomic policy hasclearly been able to increase the demand for financial assets, partly byencouraging a shift away from physical assets and partly by encouragingincreased intertemporal deferral of consumption. Such an environment hasundoubtedly been beneficial for the growth of financial intermediation inthe 19809.

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components of the financial system (MOF Bulletin, May 1987). These steps haveled to a stabilization of the structure of the financial system for the mo-ment. However, there exist other forces of change besides regulatory diffe-rences and these may generate further restructuring in the future.

Table 2.2: COMPARATIVE INTEREST RATES

Type Issuer Maturity Rate:87.12 Rate:82.1

A. Deposit Rates

Savings deposit DMB 3-6 months 9.0Z -Time deposit DMB 3-12 months 6.02 15.02Bills issued STFC 2-3 months 7.5Z 13.0XCash management account STFC 3-6 months 10.52 -

B. Lending Rates

Commercial bills discount DMB 10.0-11.5% 16XCommercial paper discount STFC 11.0-12.0Z 19.12


2.7 Status of Commercial Banks. The financial health of the bankingsystem merits further discussion. Since 1980, the banking system has to alarge extent been hostage to substantial arrears, bordering on defaults, in alarge fraction of outstanding loans. The two sectors most affected are con-struction and shipping. The scale of the non-performing loans has been suchas to potentially threaten the solvency of the main banks involved. Govern-ment has stepped in intermittently since 1980 to arrange solutions which havehad the following general structure: insolvent and delinquent firms have beenforcibly merged with healthy firms,--the mergers having been made palatable bythe offer of both tax breaks and concessional financing terms; the non-performing loans have been distributed among banks partly by fiat and partlyby the mergers, and all banks have been compensated for carrying these loans,and making fresh loans to affected entities, by special low interest discountarrangements through the BOK.

2.8 Commercial bank loans made under such restructuring arrangementsqualify for discounting at the BOK at a rate of 32 whereas the regulardiscount rate for other general loans can be as high as 82. Such subsidieshave helped support commercial bank profitability in recent years, althoughthe average profit performance during the 1980s has been much worse than inthe 1970. Whether such restructuring solutions will be successful continuesto depend critically on the performance of the affected sectors, principallyoverseas construction and shipping. They were undertaken with the hope thatthese sectors would rebound from their slump or be rendered more manageable by

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overall growth in other sectors.91 Unfortunately, the former has not yethappened despite the boom in other sectors of the economy; hence the problemof nonperforming loans, while abated, continues to exercise pressure on bankprofitability.

2.9 Part of the pressure on bank profits comes from non-payment ofinterest and part from losses taken in writing off bad loans. The amount ofuncollectable loans written off has risen gradually since 1983 as follows:664 billion won in 1984; 740 billion won in 1985; 852 billion won in 1986 and1,081 billion won in the first half of 1987. While taking some losses nowshould reduce losses to be taken in future years, this cannot be taken forgranted because there is also an element of "throwing good money after bad" inGovernment's attempts to restructure the ailing sectors. Should these sectorsnot recover, banks may have to write off new loans advanced in the restruc-turing exercises also. However, the boom in the rest of the economy has notleft banks entirely unaffected. Commercial bank profits are reported to haverisen modestly in 1986 and 1987. There is, therefore, some hope that acontinuation of the boom may sufficiently improve the profit position of banksfor them to be weaned from concessionary credit fir the BOK withoutimperiling the solvency of the system as a whole.- The strategy is one ofhaving the banks outgrow their problems rather than "solve" them.

2.10 Status of STFCs. Three factors have a bearing on the futureposition of STFC's within the overall financial system: regulatoryprivileges, competition and the continuation of the economic boom. As alreadynoted, regulatory discrimination between banks and STFCs has already beenreduced considerably in terms of interest rates and financial servicesprovided. This has led to greater competition between banks and STFC's fordeposits and loans and has thereby reduced the profit differential between the

9/ An account of the policies and events that have characterized thesesectors during the last ten years is provided in Korea: Managing theIndustrial Transition, World Bank, 1986.

10/ It should be noted, however, that recent bank profits have come largelyfrom highly profitable securities transactions in Korea's booming stockmarket and not from normal lending operations. About 61% of the netprofits of the five major commercial banks came from securities trans-actions during the first half of 1987. Non-performing loans, meanwhile,continue to drag down profits. It is reported that the two commercialbanks with the largest volumes of uncollectable loans lost about 7.5billion won in the first half of 1987 on their lending operations whilemaking a profit of 18.7 billion won on portfolio appreciation.

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two institutions.-11 The absoiute profit margin of STFCs has been even moresharply eroded by the relaxation of licensing requirements in 1982 which ledto rapid growth in the number of STFCs. There appears to be excess capacityin this segment now. This was demonstrated initially in 1985 when a moderatefalloff in economic growth led to near-bankruptcies for several STFCs. Sincethen the ongoing economic boom seems to have kept most STFCs in business--theexceptions are those who were overexposed to the eonstruction and shippingsectors. Nevertheless, there are so many STFCs in operation now, and profitmargins at some are so thin, that it is quite possible that a future slowdownin growth might trigger bankruptcies and mergers. Greater supervisoryscrutiny and a streyfhening of capital-asset ratios may be warranted forlong-run stability.-

2.11 STFCs have had a similar experience with deposits and profits sincethe onset of the current boom as have banks. While they have been prominentin the financing of the export boom, they have also suffered cash shortages asinvestors have moved funds away from STFC bills to the stock market which hasoffered much higher returns since mid-1986. On the other hand, STFCs havethemselves gained from securities transactions. Indeed, as with banks, thebulk of their profits in recent months have come not from lending operationsbut from capital gains in the stock market.

2.12 As STFCs have grown and become established in the financial systemthere is less and less of an argument for maintaining their distinct andseparate status by regulation. Evolutionary economic forces have driven manySTFCs to a state of convergence with commercial banks at least as far as thebroad structure of assets and liabilities is concerned--a major remainingdifference, as shown in the neit section, is their lack of dependence on theBOK. Given the natural tendency for convergence, a logical future regulatorystep would be to lift artificial business boundaries between DMBs and STFCsand a logical policy direction would be to encourage STFCs to merge amongthemselves or with DMBs so as to attain a size and presence that would enablethem to compete alongside existing DMBs. One clear advantage of such a

11/ Recent regulatory changes have not been entirely one-way in effect.Indeed, in April 1984, STFCs were permitted to develop Cash ManagementAccounts (CMAs) which are similar to money market mutual funds in theUnited States and which have enabled STFCs to tap household savings,albeit with some restrictions (minimum denomination is 2 million Won).CMAs have proved very popular with STFCs and their customers--theyaccounted for 24Z of STFC liabilities within a year of their introductionand stand at 50% currently.

12/ At present, STFC's are required to keep their total indebtedness,including issuance of their own paper and guarantees on commercial paper,to less than fifteen times paid-in capital and reserves. This translatesto a capital-asset ratio of about 6.5. While this may be appropriate byinternational standards it may not be sufficiently prudent in view oftypical STFC exposures in Korea.

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development would be enhanced effectiveness of monetary control, a pointdeveloped more extensively in a later section (see Section 2C).

Table 2.3: FINANCIAL CONDITION OF BANKS AND STFCs

1980 1985 1987Banks /a STFCs Banks STFCs Banks STFCs

Liabilities(billion won) /b 11,938 1,214 29,775 4,762 30,121 7,943

x of liabilitiesCapital 2.7 8 2.6 10 3.6 7Surplus /c 4.8 - 4.2 6 2.6 6Borrowingsfrom BOK 14 - 21 - 17 -

Profit rate /d 15.5 42.3 3.9 12.7 5.3 12.3

/a "Banks" refers to only the seven nationwide commercial banks.7T Total liabilities and net worth exclusive of acceptances and guarantees

for banks and exclusive of bills sold without recourse for STFCs./c Sum of capital surplus (reserves) and earned surplus (profits).7- Net profit/capital

Sources: Monthly Statistical Bulletin, Bank of Korea.

2.13 Linkages. An overview of the linkages between the various compo-nents of the Korean financial sector reveals a very clear pattern: DMBs andDIs are strongly linked to the BOK but weakly linked to each other and to theSTFCs; the latter are the most independent.

2.14 The strong links between DMBs and the BOK arise in several ways:DMBs are subject, in principle, to control via all six of the monetary controlinstruments available to the BOK (see Table 2.4). More fundamentally,however, the links are present because Government used DMB's extensively asinstruments of industrial policy. This role consisted essentially of DMB'sproviding credit, at Government direction, to preferred sectors, anarrangement covered by the term "policy loan". Such loans often put DMBaccounts in deficit and necessitated their going to the BOK for discountloans. Policy loans can be more easily discounted through the BOK and havetypically carried lower discount rates. In addition, the BOK has oftenprovided profit support to DMBs by paying discretionary interest on requiredreserves. Thus, strong links were established both because banks, acting assuppliers of credit at Government direction, were chronically in deficit aswell as because of the incentives provided by the BOK in the form of cheapdiscounts and interest on reserves.

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2.15 The links were stronger in the 19709 than they have been in the1980s. Presently, around 20X of the aggregate liabilities of commercial banksconsist of borrowings from the BOK; during the 1970s, this proportion wastypically around 30X. In recent years, the DMB's have also been used asfinancial conduits for several government-sponsored industrial restructuringexercises, a role in which they have had to accept nonperforming commercialloans in return for special subsidized discount arrangements with the BOK.Thus DMBs are linked to the BOK by regulation, by need and by fiat.

2.16 DMBs are, however, quite independent of STFCs and of each other.This is reflected in the lack of an active interbank market in Korea. Veryfew transactions are conducted in this market and there are restrictions notonly as to the volume and frequency of transactions but also to the nature ofthe instruments traded and the participants. The fact that STFCs, which havetraditionally been surplus units in the financial system, are not allowed toparticipate freely in the interbank market is a major reason for its lack ofdevelopment.

2.17 The paucity of linkages between DMBs and STFCs is also reflected inthe negligible extent to which the two components hold each other's paper.DMBs, being deficit-prone, are generally unable or otherwise reluctant to holdSTFC bills in their asset portfolio. STFCs do not hold DMB paper because DMBscannot issue commercial paper; nor do STFCs place significant deposits withDMBs because the administered deposit interest rates are not as attractive asalternatives available in the money and capital markets. Cash and depositsconstituted less than 7X of the assets of STFCs in 1985; deposits in DMBsconstituted less than 4Z.

2.18 Finally, STFCs are independent of most of the levers of monetarycontrol. They are not subject to reserve requirements, they do not havediscount privileges at the BOK, and they have not been subject to directcredit controls except to the extent of beili,required to allocate 35% oftheir loans to small and medium industries. They have traditionallyenjoyed higher ceilings on the interest rates they can apply to loans andborrowings. The only instruments they are connected to are open marketoperations; in recent months they have been important purchasers of MonetaryStabilization Bonds (MSBs), instruments which carry interest rates that aremore sensitive to market-based lending rates.

13/ The deposits kept by STFC's with DKBs constitute a form of requiredreserves: the BOK imposes certain liquidity requirements on STFCs whichcan be met by placing deposits with DMBs. The monetary effects of such arequirement, however, are far less severe than of true reserve require-ments.

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Table 2.4: INSTITUTIONS AND INSTRUMENTS

Reserve Direct InterestCategories of Require- Discount Open market credit rateinstitutions ment operations operations controls controls

Commercial banks H H M H H

Specialized banks H H M H H

Developmentinstitutions H M M M H

STFCs L L H L M

Savings institutions L L H L M

Insurance companies L L H L M

Note: H and M refer to high and moderate degrees of application. L meansthat the instrument is not applicable

B. Use of Monetary Instruments

2.19 The degree of reliance on individual monetary instruments has variedin Korea in accordance with three factors: the magnitude of credit demandfrom the public sector as reflected in the fiscal deficit-GNP ratio, thehealth of the banking system, and the scale of liquidity variations arisingfrom the foreign sector. Before 1979-80, the prevailing philosophy was one ofpublic sector priority so that relatively large fiscal deficits were run and,if these led to monetary pressures, those pressures were either accommodatedthrough higher inflation or offset by the use of reserve requirement changesand direct credit controls. Open market operations, featuring market interestbased instruments, were avoided in order to protect the treasury from debtservice obligations. As a result, a broad and active government securitiesmarket was not developed. Since 1980, however, fiscal deficits have beensharply reduced and open market operations have been used to finance a largerpart of these deficits than before. Moreover, concerns about the financialhealth of the banking system have restricted the contractionary use of otherinstruments such as reserve requirements and discount operations. Since 1985,a third factor has come into play in the form of liquidity expansion throughexternal surpluses: so rapid and substantial has this expansion been thatdirect credit controls have been revived and are being used together tth openmarket operations. The role of these factors may be seen more clearly in thefollowing discussion of individuel instruments.

2.20 Reserve Requirement Ratios (R&Rs). This instrument was quitepopular until 1981--indeed, the RRR was changed on at least 18 occasions

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during the period 1965-81. Generally high RRRs were kept in force until 1981;indeed, on one occasion in 1966, a surge of liquidity from the external sectorwas countered by raising the RRR to 35Z for demand deposits. Since 1981,however, the level of the RRR has been much lower and the instrument hasfallen into disuse because of its adverse effects on commercial bankprofits. These have generally been low in Korea and have been seriouslyaffected by nonperforming loans in recent years. Furthermore, commercialbanks often failed to meet this requirement and had to borrow from thediscount window at a penalty rate to make up the reserve deficiency. This notonly affected their profits adversely, it also defeated the purpose of therequirement. In addition, this instrument could not be used flexibly andselectively. Changes affected all DMBs and the effects could often be rathersevere on specific banks. In view of these considerations, the RRR wasreduc T,sharply from 19% to 5.5% in July 1981 and further to 4.5% in September1984.- The fact that it is so low and that it applies only to DMBs, who nowaccount for less than 50% of deposits, clearly limits its effectiveness as amonetary instrument at present and indicates that the instrument is being usedto only a fraction of its potential.

2.21 Monetary Stabilization Account. Problems encountered with reserverequirements have often prompted recourse to a different instrument whichprovides greater flexibility and selectivity. This instrument, called theMonetary Stabilization Account (MSA), is similar to a reserve requirement inthat banks are required to deposit certain amounts in such accounts with theBOK. Variations in the Account balance can be mandated by the BOK, therebyaffecting the overall liquidity of banks. The MSA is interest-bearing and canbe applied to any or all depository institutions to extents determinet by theBOK in line with its perception of overall monetary objectives as well as thereserve position of individual banks, thereby providing selectivity ofcontrol. This instrument has been frequently used since its introduction in1967. In recent years, however, the use of this instrument too has falleninto abeyance because of concern about the potential effect on the financialhealth of banks.

2.22 Rediscount Operations. Rediscount operations have two dimensions,price and quantity. The price dimension is reflected in the discount ratecharged by the BOK on loans and discounts whereas the quantity dimension isreflected in the actual volume of such activity. The BOK has traditionallynot been able to use the discount rate as an effective monetary control toolbecause of a chronic excess demand for discount credit among Korea's commer-cial banks, a demand that has proven to be inelastic with respect to the dis-count rate. Instead, the BOK has relied on credit rationing at the discountwindow, usually conducted through the setting of maximum rediscount ratios fordifferent types of loans. This has meant that in practice discount transac-tions have essentially been used both as a means to charnel credit to pre-ferred sectors and as a means to control the overall volume of credit, i.e.,both as an industrial policy tool and as a monetary policy tool. It wouldappear that during the 1970s the industrial policy aspect overshadowed the

14/ The RRR was raised to 7% in November 1987.

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monetary control aspect as rediscounts were liberally used to fund industrialinvestments, especially for export purposes. Furthermore to the extent thatrediscount rates were considerably lower than other representative interestrates, discount operations provided a substantial subsidy to banks - theappropriate use of such operations as monetary control tools was thusconstrained by solicitude for the ultimate effects on banks profits.

2.23 The dual nature of discount operations can be seen quite clearly inTable 2.5 which compares rates of growth of M2 and discount volumes in recentyears. During 1982-84, Government implemented a substantial contraction ofthe money supply, bringing M2 growth down from 27% to 8%. This contractionarystance was in line with the objective of reducing inflation and enhancingexport competitiveness. At the same time, however, Government was confrontedby a financial crisis brought on by massive potential bankruptcies amongshipping and construction firms. It dealt with this crisis by restructuringthe affected sectors and providing special financing arrangements to affectedbanks to help them carry the nonperforming loans. These activities arereflected in the growth of discount volumes of 23%, 25% and 32% respectivelyin 1982, 1983 and 1984 when M2 growth was in a sharp contractionary mode.

Table 2.5: DISCOUNT VOLUMES AND MONETARY GROWTH

1982 1983 1984 1985 1986 1987

Volume of loans and discounts 4,609 5,766 7,623 9,641 10,157 10,783(in billion won)

Rate of growth of loans and 23 25 32 26 5 6discounts (X)

Rate of growth of M2 (%) 27 15 8 16 19 22.5


2.24 The present status of discount operations remains largely the samealthough, unlike typical past situations, their orientation is not as heavilybiased towards monetary expansion. This is becalgye rediscount ratios haverecently been sharply reduced for export loans. This step has been takento reduce the rate of growth of exports and thereby that of the external

15/ The average export financing loan available for each dollars worth ofexport letters-of-credit was cut in May 1987 to 475 won for large tradinghouses and 630 won for small ones, down 185 won and 70 won respectivelyfrom the end of 1986. The exchange rate appreciated from 860 won to 810won to the dollar during this period.

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surplus. Such a reduction will ultimately have a contractionary impact on themoney supply. This should offset the expansionary effects of discountsprovided in support of directed bank lending to verfgys preferred sectors suchas the depressed construction &ad shipping sectors._

Table 2e6: RECENT DEPLOYMENT OF MONETARY INSTRUMENTS

Instrument Unit 1985 1986 1987

RRR X 4.5 4.5 7.0Volume of rediscounts W bln 9,641 10,157 10,783Rediscount rate /a t 3.0-5.0 3.0-7.0 3.7-7.0Sale of MSB% (neEY W bln -2,596 2,395 4,916Sale of FESBs (net) /b W bln 0 0 1,480MSA (net change) W bln 5,326 -1,126 -2,246

/a The rediscount rate varies by purpose of loan. In July 1986 therediscount rate on commercial bills and export loans was raised from 52to 72; agricultural loans are rediscounted at 3Z; general loanc ordiscounts extended in support of industrial restructuring exercises carrya rate of 32.

/b Foreign Exchange Stabilization Fund Bonds.

Sources: Monthly Statistical Bulletin, Bank of Korea, Ju.e 1987.

2.25 Open-Market Operations. Open-market operations have not tradi-tionally been used in the service of monetary policy. The single most im-portant reason for this is that Government was not keen in the past to paymarket or even close-to-market rates of interest on internal public debt.When opportunities arose for the exercise of open-market operations, Govern-ment preferred to use other means to achieve its objectives. For example, itpreferred to borrow money directly from the BOK (at zero or close-to-zerointerest rates) to finance budget deficits. On other occasions, when the needwas monetary and not fiscal in origin, that is, when there was excessiveliquidity in the economy, Government chose to reduce this liquidity not byissuing securities but by using direct credit controls on banks and/oradjusting RRR or the NSA. When open market instruments were used, indeed,they were not actually placed in the "open" matket but in a captive market of

16/ The conflicting objectives of discount operations are evident in thecomposition of rediscounts. While BOK loani for export financing droppedby 1,618 billion won (upto August 1987) as a result of changes in exportfinancing arrangements, loans for general purposes, involving chieflyrestructuring loans to support the construction and shipping sectors,increased by 1,076 billion won.

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banks. The securities so placed were typically MSBs which are liabilities ofthe Bank of Korea rather than regular government securities. However, out ofconcern for banks' profits, MS8s have typically carried rates of discountsimilar to the interest rates on deposits of comparable maturity.

2.26 Since 1981, the monetary authorities have sought to develop a truerand more active open market. This is being done in several ways. First,Government has been relying increasingly on the sale of government securitiesto finance its fiscal needs. For example, the deficit from the Grain Manage-ment Fund, which hoe been the principal source of deficits in the overallfiscal account, has recently been financed largely through the issuance ofGrain Securities. Second, government and BOK securities are being placed to agreater extent in the larger financial market and especially among nonbankfinancial intermediaries. This is being done by offering relatively attrac-tive yields on these securities. For example, MSBs currently offer a yield of12.8% while short-term government bonds offer a yield of almost 15%. Theseyields relate favorably, when adjusted for risk, to corporate bond and commer-cial paper yields (currently between 132 and 14X).

2.27 The absence of a government securities market in Korea denies theBOK a policy instrument that would be ideal in a financially liberatedenvironment. While technically pvoviding the BOK with an open market instru-mentt MSBs are not desirable as a long term open market instrument for severalreasons. First, MSBs impose a rather high interest cost on the BOK. Interestpaid on MSBs in 1987 came to W 900 billion or 532 of total BOK operatingexpenses. Other things held constant, an increasing interest burden willlower net worth and thereby increase the gap between assets and liabilitiesplus capital. The BOK will then be required over time to use other policyinstruments (or purchase outstanding M5Bs) to offset the positive effect onthe monetary base. Second, the uneven distribution of the MSEs reflects theprotected place of the banking system in the transmission of monetarypolicy. MSBs are purchased by nonbank financial institutions and others whilebanks are provided with subsidized rediscounts. The net effect of the twooperations might be in the proper direction, but the overall effect isachieved via an uneven distribution of the effects of monetary policy. Third,the manner in which MSBs have been used confuses separate functions of thegovernment. Open market operations should be conducted to achieve the basicobjectives of monetary policy, that is, to achieve a stable and low inflationrate. At present, however, operations in MSBs are influenced by the need tosupport credit allocation objectives and to support financially weak banks.

2.28 Government has introduced several facilities to ease the absorptionof monetary control bonds. One such facility is designed to broaden theownership of such bonds by encouraging corporations to invest in them.Businesses can now open corporate trust accounts, with a minimum of 5 millionwon, 80% of the funds in which are to be invested in liquidity control bondsand 20% in conventional bank loans. These accounts carry interest rates of102 and 11.3% for 3 month and 6 month deposits respectively as compared to7.5% for STFC 3 month bills and 6% for DMB 6 month deposits; hence they areexpected to be very popular among large depositors.

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2.29 By providing a risk-free intermediation spread of about 1% thismeasure may also benefit efficient banks. It is not clear, however, howsuccessful this measure will be. (This measure was announced around the endof September 1987.) After all, the chief reason for excluding DMBs from open-market operations has been the desire to reserve their funds for lending tofinancially ailing industrial sectors. The extent of the ailment has notabated in any significant way. Diverting DMB funds into MSB purchases willreduce the amount of funds available for continued ministration to unhealthycompanies and, in the process, perhaps consign some to bankruptcy. Whetherthe authorities are willing to accept the consequences of such a move remainsto be seen. If they are, this would be a positive sign of their intention toseparate monetary control objectives from industrial policy objectives and notallow the latter to interfere with the former.

Table 2.7: DISTRIBUTION OF THE NET INCREASE IN MSBs FOR 1986 AND 1987(Billions of won)

1986 1987Amount Percent Amount Percent

Net Increase 2,754 (100.0) 4,916 (100.0)

Distribution:Investment Finance Companies 599 (21.8) 1,374 (27.8)Investment Trusts 527 (19.1) 539 (11.0)Securities Companies 509 (18.5) 1,188 (24.2)Life Insurance Companies 369 (13.4) 628 (12.8)Agricultural Mutual Credit 340 (12.3) 80 (1.6)Other nonbanks 410 (14.9) 1,107 (22.5)

Source: Bank of Korea

2.30 To effect a broader and more efficient distribution of monetarycontrol securities, the authorities introduced a system of primary dealersearlier this year. The institutions designated as such were mostly STFCs andsecurities companies who, as Table 2.7 shows, have also been the principalpurchasers of MSBs recently. The large volume of monetary control securitiesissued in 1987, however, has strained the underwriting and portfolio capacity

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of the designated dealers.171 This, and the prospect of similar issuancevolumes in the future, has prompted the authorities to set up a larger networkof underwriters for such securities, a network which is to include a greaternumber of NBFIs. In particular, a Bond Management Fund is to be establishedjointly by three investment trust companies to underwrite and purchase MSBsand other liquidity control bonds. Individuals and institutional investorscan participate in the Fund through the purchase of beneficiary certificatesand other secondary securities.

2.31 Direct Controls. Direct credit and interest rate controls havetraditionally been Korea's most important instruments of monetary stabiliza-tion. The Bank of Korea is empowered to set deposit and lending rates (orbands) for all banks and nonbanks as well as to fix ceilings on creditexpansion even to the extent of approving individual loans. As a result, ithas been able to skip open market and discount operations and go straight tothe ultimate targets of monetary control, interest rates and credit availa-bility. It has applied these instruments with degrees of motivation andsuccess that have varied in accordance with such factors as the magnitude andspeed of monetary disturbances, the need to maintain a high level of domesticsavings simultaneously with adequate investment in the manufacturing sectorand reasonable profits in the banking sector, and also with the changingstructure of the financial system.

2.32 In many respects, these direct methods can be superior to the indi-rect methods of implementing monetary policy. This is certainly true from thepoint of view of control and targeting--the cost and availability of creditca: be immediately changed by exercise of direct controls. Also, directcontrols are more powerful than such instruments as open market and discountoperations since they affect lending and investment decisions directly withoutbeing modified by the behavior of the banking system.

2.33 Furthermore., when monetary disturbances are large and rapid innature, the monetary authorities have found it difficult to bring about

17/ The large amount of sterilization already conducted and the prospect ofmore to come has begun to have a noticeable effect on the bond market andon the attitude of STFCs and securities companies, the principalpurchasers and underwriters of MSBs. Increased supply of MSBs in recentmonths has pushed prices down and interest rates up in the bond market;the yield on MSB's have been pushed up from 12.2% to 12.8% in the primarymarket and up to 16% in the secondary market. It is also reported thatSTFCs have been dumping MSBs on the secondary market to raise funds forregular lending objectives, and even sustaining losses in the process.

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monetary stabilization through indirect control mechanisms.181 For someperiod after 1965, indirect methods were relied upon to an increasing extentin the implementation of monetary policy. However, the surge in inflation in1977-79 and the oil shock of 1979-80 prompted a return to direct controlsduring the period 1977-81: interest rates were raised by large amounts (from14% to 24Z) and ceilings were placed on credit expansion of individual banksin order to counter monetary expansion and inflationary pressure.

2.34 As the inflationary shock of the 1977-80 period subsided, the mone-tary authorities began re-emphasizing indirect instruments, principally open-market operations. However, the surge in liquidity occasioned by the largecurrent-account surpluses achieved since mid-1986 have once again prompted areturn to direct methods, principally to credit ceilings on commercial banks.At the same time, however, open-market sterilization operations continue to beconducted. Finally, it should be emphasized that, in practice, direct con-trols are not as stringently or effectively exercised on STFCs as on DMBs.While STFCs are subject to interest rate controls, they have not been subjectto credit controls and asset or liability management to any appreciable de-gree. Thus, as structural changes have increased the role of NBFIs in thesystem, the effectiveness of direct controls, as presently exercised, hasdeclined.

2.35 Assessment. The above review supports the following generalizationsconcerning the Korean monetary system:

(a) The system has not been sufficiently flexible in terms of the use ofvarious instruments; the weak financial condition of the bankingsystem and the assignment of discount operations to industrialpolicy objectives has constrained the appropriate deployment ofmonetary instruments.

(b) There is still extensive reliance on direct control of the cost andavailability of credit as a means of influencing the level ofeconomic activity; however, much progress has been made recently inpromoting the use of market mechanisms for the transmission ofmonetary policy, chiefly through the sale of MSBs in open marketoperations. Such operations, however, are limited by the lack of abroad and active government securities market.

18/ This is not to say that direct controls and window guidance are to bepreferred on all counts or even perhaps on balance. Among the manyproblems generated by indiscriminate and excessive reliance on directcontrols are: inefficient investments, arising from the lack of marketsignals with regard to the associated risks and rewards, costs andreturns; inefficient banking practices, arising from the diffusion ofresponsibility for credit decisions and the lack of need to performrigorous credit analysis of borrowers; and stymied development of thefinancial sector, arising from insufficient incentive to innovate.Direct controls are inconsistent with the development of an efficientmonetary system in the long run even though they may be fairly effectivetools of control in cae short run.

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(c) Different instruments are used for aifferent intermec;sries and itis difficult to judge whether the incidence of monetary policy isbalanced across financial institutions and categories of firms.Since considerable structural change has occurred in the last decadeor so it would be useful to consider its implications in moredetail. This is taken up in the next section.

C. Implications of Changes in Financial System

Innovations and Control

2.36 Since the early 1970s, changes in the financial systems of the majorindustrial countries have given rise to much concern about the erosion ofmonetary control. While these changes have varied in magnitude and timingacross individual countries a number of generalizations can be sustainedregarding their origins and effects. Their origins are to be found princi-pally in attempts by private economic entities to circumvent, offset or other-wise escape the effects of binding regulations expressed in such forms asinterest rate ceilings, reserve requirements and direct credit controls.Their effects have principally been those of rendering volatile and uncertainpreviously well-established relationships between monetary instruments,targets and objectives and imparting an expansionary bias to monetaryactivity.

2.37 The US provides a good example of the origins and effects of finan-cial innovations. Since the early 1970s a large number of innovations havebeen introduced in the US financial system, the chief among which are probablynegotiable certificates of deposit, one-bank holding companies, offshorebranching, repurchase eements, money market funds and future markets infinancial instruments. All of these innovations were a means largely toenable banks to borrow and lend funds that were not subject to reserverequirements, capital-asset ratios and binding interest rate ceilings. Indivi-dually and collectively they have weakened the ability of the monetary autho-rities to restrict liquidity through traditional monetary instruments and mayhave increased the fragility of the financial system. Opinion is by no meansunanimous on the ultimate desirability or undesirability of such financialinnovations. While some have applauded such innovations as welfare-enhancingmeasures, others have noted with regret and dismay the anarchy and financialimprudence that they have promoted.

2.38 Innovations have also occurred in the Korean financial system, espe-cially in recent years. As already noted, new financial institutions andinstruments have proliferated since the late 1970s, so much so that over halfthe assets in the financial system are now accounted for by the NBFI's andover half the liabilities are now in the form of new instruments such ascertificates of deposit, commercial paper and cash management accounts. M3

19/ For an exhaustive account of these innovations and their effects, seeHester (1981). For an international perspective, see Akhtar (1983).

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has grown at a much faster rate than K2 for over a decade now.201 In additionto these innovations, various reform measures have resulted in the denationa-lization of banks, the granting of more autonomy to bank managers with regardto asset and liability management and lower reserve ratios. It is fairlyclear from international evidence that such changes in the financial systemweaken monetary control exercised in traditional ways. Where a high degree ofcontrol is deemed necessary for macroeconomic purposes new regulations areoften necessary. In the US, for example, innovations and new regulations havefollowed each other in cat-and-mouse fashion. As the ability to influencemacroeconomic activity was felt to weaken after each round of innovations theFederal Reserve System found it necessary to extend its surveillance, super-visory authority and reserve regulations to a broader and broader set ofintermediaries and deposit-types, and asset management practices.

2.39 Controlling NBFI Liquidity Behavior. We have already noted the apriori basis for expecting weakened monetary control in Korea as a consequenceof the changes that have occurred in the financial sector: over half of thedeposits in the system are now not covered by reserve regulations and almosthalf of the loans are neither subject to direct controls nor manipulablethrough discount operations. As Table 2.4 shows, only one instrument, theopen market sale 2fj,MSB's, is presently being used to control the liquidity ofthe NBFI segment.- Indeed, there is evidence that suggests that monetaryrestraint applied to banks (through control of M2, for example) is oftenpartially offset by expansion generated by STFC's.

2.40 Such a pattern may be detected in the behavior of M2 and M3 inrecent years, especially in periods when the authorities have tried to curbliquidity sharply. For example, during 1984, M2 growth was brought sharplydown to 7.7% from 15.2X in 1983 (see Table 3.1). However, M3 growth remainedvirtually constant at around 20% (compared to 21.6% in 1983). Similarly, asthe authorities have sought to contain the liquidity surge (since mid-1986)from the foreign sector by keeping M2 growth at around 18%, M3 growth hassurged from 21% in 1985 to around 30% currently. An even sharper pattern ofoffsetting liquidity movements can be discerned by distinguishing between thegrowth of M3 components originating in DMBs and government-controlleddevelopment finance institutions and those originating in STFCs.

2.41 One way for the monetary authority to increase the degree of mone-tary control in the present circumstances would be to extend reserve regula-tions to NBFIs such as STFCs and savings institutions. A complementarymeasure would be to extend such regulations to all types of deposits held in

20/ The difference in the rates of growth of M2 and M3 can be judged from thefact that whereas the stock of M2 was about 78% of M3 in 1977, it haddeclined to around 49Z by 1987.

21/ The activities of STFC's are also controlled by ceilings on CMAs and byoverall liquidity and capital-asset requirements. However, from amonetary control standpoint, the most important levers at present areopen market operations.

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DMBs and the USFIs noted above. These measures can be justified on botheffectiveness and equity grounds. There is no good reason, for example, whytime deposits at DMBs should be subject to reserve requirements but comparabledeposits at STFCs and savings institutions should not. Uniform reserverequirements across institutions and deposit-types eliminate the effect on themoney supply of shifts in deposits among institutions and matuI'ties andthereby provide more effective control over the money supply.T To theextent that the most appropriate indicator for monetary targeting is the broadmeasure of liquidity, M3, (a point discussed in a later section), effective-ness of control is also enhanced by bringing all the deposit components of M3under uniform reserve requirements. Furthermore, now that STFC's and savingsinstitutions have become well-established, fairness requires that theirregulatory advantages vis-a-vis DMBs be reduced, as would happen if they werealso subjected to RRRs.

2.42 Clearly the pay-off in terms of liquidity control would besubstantial. If a 4.5% RRR was imposed on STFC and savings institutionsdeposits, M3 should shrink by 1.2 trillion won, a rather large effect comparedto the expected sterilization requirement of 6.5 trillion won in 1987-88.This is not surprising, of course. Reserve requirements are blunt toolsappropriate for inducing large monetary shifts. In this respect, they may bebetter for dealing with Korea's prospective monetary problem, which is of ascale unprecedented in its experience to date, than more precise tools such asopen market operations.

2.43 A further advantage of reactivating RRRs as a monetary instrumentwould be that government policy intentions would be clearly and unequivocallycommunicated to the relevant economic agents. Reserve requirements, becausethey have large effects on the economy, have desirable "announcement"properties: they convey clear signals.

Resource. Allocation Concerns

2.44 Resource allocation neutrality is a desirable characteristic for agood monetary system. This can be interpreted to mean that monetary policymust not affect the relative terms on which credit is made available todifferent domestic borrowers in the process of transmission through theinstitutional structure. Such effects do not normally occur in a monetarysystem featuring well-integrated credit and capital markets in which monetarysignals can be communicated quickly and without impediment. They could occur,however, if the monetary system is highly segmented, so that the effects ofmonetary operations conducted in one part, say the bank segment, are noteasily transmitted to the other parts and further if borrowers are alsosegmentedtso that some only have access to banks while others only to

1~~~~~~~~~~~

22/ This could also be achieved by incorporating STFCs and savingsinstitutions within the statutory definition of DMBs or by merging themwith DMBs; the advantage of re-chartering would be that these NBFIs wouldthen be entitled to the deposit-accepting privileges of DMBs, perhaps afair compensation for being made subject to RRQs.

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nonbanks. Such resource allocation effects are undesirable because they maybe inconsistent with other government policies (e.g., maintaining credit flowsto small and medium industries), they may introduce distortions that generateinefficiency (e.g., if the domestic sector is unduly starved of funds relativeto the export sector) and they may create political opposition to monetarypolicy operations on equity grounds, opposition that would most likely affectthe independence of the monetary authority.

2.45 The ultimate resource allocation effects of monetary policy aredetermined by both the extent to which the relative terms of credit (i.e.,cost and amount) are changed for different categories of firms and the extentto which these categories of firms are affected by such changes. In otherwords, the overall effect of monetary policy will depend not only on whatproportion of an intermediary's loans go to a particular category of firm butalso on how important that category of financing is to the borrower. Thefirst effect is a function of the structure of financial intermediation asexpressed by the respective credit allocation patterns of the chiefintermediaries. The second effect is a function of the financing structure ofdifferent categories of firms, i.e., the extent of their reliance on banksversus nonbanks and other sources of funds such as equity markets. Thus thedirection of potential resource-allocation biases can be assessed through anexAmination of these factors. We have already noted that UBFIs now accountfor a significant fraction of lending and hence have the potential tosignificantly influence the relative terms of credit cost and availability.The next section reviews the credit allocation profiles of DMBs and NBFIs.This is followed by a review of corporate finance structures for variouscategories of firms.

2.46 Pattern of Credit Allocation. A review of the sectoral allocatioof credit by DMBs and STFCs reveals the following patterns (see Table 2.3):3/

(a) Both categories of financial intermediaries allocate a similarpercentage of their loans to the manufacturing sector (44% for DMBsversus 47% for NBFIs);

(b) A major difference between the two categories occur with respect tolending to agriculture; DMB's lend almost 9% of their loans toagriculture whereas NBFIs lend less than 1%.

(c) A similar difference occurs in the case of wholesale and retailtrade and hotels: DMB's commit a larger proportion of theirportfolio (28%) to this category than do NBFIs (12%)

The above-described patterns suggest that if monetary restriction is appliedonly to banks, and both banks and nonbanks maintain their pre-restriction loanportfolio patterns, the sectors that stand to lose relatively are agriculture,

23/ The data on which this account is based pertains to the credit allocationpatterns of all NBFIs other than Development Institutions; thus, the datalargely tend to reflect lending patterns of STFCs, mutual savings andfinance companies and insurance companies.

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wholesale and retail trade, and hotels. On the other hand, if monetaryrestriction is applied only to STFCs, these sectors will benefit relative tothe manufacturing sector in that credit flowing to them will be reduced by asmaller fraction than credit flowing to the manufacturing sector.

Table 2.8: SECTORAL ALLOCATION OF CREDIT (in Z)

Average for 1984-86Sector DMB Non-banks /a

1. Agriculture etc. 8.6 0.82. Mining 0.5 0.63. Manufacturing 44.3 47.34. Electricity, Gas and Water 0.4 0.45. Construction 15.8 16.26. Wholesale/retail trade; restaurants

and hotels 28.6 12.17. Transportation etc. 2.9 4.58. Finance, insurance, real estate etc. 2.9 3.69. Community and personal services 5.5 2.710. Other 11.6 12.9

/a Non-banks refer here to all NBFI's other than Development Institutions.


2.47 Direct information is not available on the pattern of creditallocation with respect to categories 3uch as export and domestic goodssector. A rough assessment can be made, however, by noting that export-oriented firms are likely to be entirely a subset of the manufacturing sectorwhile domestic goods oriented firms cover the remaining sectors. If thecredit allocation profiles of banks and NBFIs are disaggregated only by thecategories of manufacturing and nonmanufacturing sectors, they look verysimilar. Therefore, allocative biases arising from choice of intermediary XZlikely to be comparatively muted with respect to these categories of firms.-

24/ We are again assuming that banks and nonbanks maintain their pre-restriction loan patterns. This assumption may not be valid in caseswhere monetary restriction is applied via direct credit controls andbanks are "guided" to restrict credit more to some sectors than to otherswhile STFCs are not so guided. In the past it has not been unusual forexport-oriented firms to be given preference over other firms in accessto credit both via specific instructions given to banks and viaincentives made available to banks in the form of easy and cheap exportloan discounts. However, such practices and incentives have declined inrecent years.

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2.48 As far as credit allocation by scale of industry is concerned, bothbanks and STFC's are required to allocate 351 of their loans to small andmedium firms. Hence no allocative biases are likely to result if monetaryrestraint is applied to banks rather than STFC's, or the other way around.The credit allocation profiles of NBFIs other than STFCs are not known.

2.49 On the basis of the foregoing there would appear to be a presumptivecase for expecting monetary restraint to be non-neutral in its allocativeeffects by sector but to be roughly neutral with respect to scale and theexport versus domestic orientation of firms. in other words, choice ofintermediary seems to matter for different sectors but not for small versuslarge firms or for export versus domestic firms. The ultimate impact of sucheffects depends also on differences in corporate financing patterns.

2.50 Corporate Borrowing Patterns. Table 2.9 shows the percentage ofliabilities originating fromi various sources for firms in different sectors ofthe Korean economy. The large variance in the pattern of financing suggeststhat monetary policy is likely to have sectorally non-neutral allocativeeffects. Manufacturing, construction and transport sector firms raise almost40% of their borrowed funds from banks (domestic and foreign) whereas mjping,real estate and recreation sector firms raise less than 20X from banks.'-Similarly, the degree of reliance upon non-banks varies considerably amongsectors. Juxtaposing the two patterns leads to the inference that monetaryrestrictions applied only to bank loans will tend to fall relatively moreheavily on such sectors as electricity, manufacturing, construction andtransport because the differences in their degree of reliance upon banks andnon-banks are the most severe among all the sectors.

25/ The electricity and gas sector is an outlier. It gets almost 75% of itsfunds from banks and about 54% from foreign loans. To the extent thatthe current monetary environment features a freeze on all foreign loans,one would expect this sector to be drastically affected.l

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Table 2.9: SOURCES OF BORROWING, BY SECTOR(Average for 1984-86, X)

Proportions of liabilites borrowed from:Foreign Non-/a

Sector Banks Loans Banks Bonds

Fishing 34.5 1.7 11.1 5.5Mining 10.1 4.2 17.9 2.8Manufacturing 33.7 8.9 9.3 7.9Electricity & gas 21.8 54.2 1.6 9.4Construction 37.6 1.6 14.0 8.0Wholesale & retail trade 24.4 5.4 14.7 6.8Transport & storage 33.7 7.5 7.1 2.9Real estate & business services 13.8 0.1 4.7 10.6Recreational, cultural & other services 14.2 4.2 6.4 0.7

ia Non-bank loans refer to loans taken from the curb market and from NBFIsother than Development Institutions.

Source: Financial Statements Analysis, Bank of Korea.

2.51 The relative importance of different sources of debt financing forsmall and large firms and for domestic versus export-oriented firms is shownin Table 2.10. The data shown are taken from regular surveys but provide onlya partial picture of the pattern of corporate financing because they do notinclude information on equity financing. It is generally agreed, however,that large firms and export-oriented firms have significantly better access toequity funds. As far as debt financing is concerned, it appears fromTable 2.10 that small and medium firms are not very different from large firmsin their reliance upon bank funds (domestic and foreign). Approximately 40Zof the liabilities of each group are accounted for by such funds. There doesappear to be a difference in reliance upon non-bank funds, however, with largefirms showing the greater reliance.

2.52 This pattern and trend of financing suggests that recent governmentmeasures to increase small and medium firm access to bank credit and toencourage large firms to diversify their sources of financing may beworking. Indeed, SMI firms appear to have reduced their reliance on STFCs andthe curb market as access to bank credit has (apparently) improved.

2.53 This skewed pattern of reliance on banks and non-banks suggests thatthe resource allocation effects of monetary policy will differ depending on

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the intermediary most (or least) affected.261 If monetary restraint isapplied principally to domestic banks, SMI firms are likely to suffe- relativeto large firms. Even though the intermediaries themselves may not introduceresource allocation biases (since both banks and STFCs, for example, mustreserve 35% of their credit for SMI firms), the degree of credit scarcity islikely to be greater for SMIs in 7 ?eriod of tight monetary policy becausethey are more dependent on banks.-

Table 2.10: SOURCES OF BORROWING, BY FIRM SIZE AND ORIENTATION(Averages for 1984-86, )

Proportions of Liabilities Borro ed From:Banks Foreign Loans Non-Banks la Bonds

Firm size1. Large 33.1 7.4 9.8 8.62. Small & Medium 37.3 1.7 6.4 3.7

Orientation3. Export 38.0 8.7 7.1 5.74. Domestic 31.9 5.6 10.8 9.3

/a Non-bank loans refer to loans taken from the curb market and from NBFIsother than Development Institutions.

Source: Financial Statements Analyses, Bank of Korea.

2.54 The pattern of debt financing for export and domestic firms suggeststhat the former have better access to domestic and foreign bank funds (whichform about 47% of their liabilities) but are not as reliant upon non-banks asare the latter. Again, these differences suggest that the choice of inter-mediary to be used for monetary policy transmission could have resourceallocation effects even though the intermediaries themselves do notnecessarily discriminate strongly between these categories of firms.

26/ The choice of intermediary of course, is not the only factor determiningultimate allocation effects. Japanese experience suggests that whenlarge firms face credit tightness from banks they pass along much of thesqueeze to their SMI subcontractors by varying payment dates ondeliveries.

27/ If foreign loans are also included, however, then the difference indegree of reliance upon bank loans (domestic and foreign) almostvanishes. Indeed, if monetary restrictions are applied principally toforeign borrowing, large firms would be more seriously affected then SMIfirms.

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2.55 Assessment. Monetary policy has the potential to be allocativelynon-neutral because of differences in credit allocation patterns amongintermediaries and funding patterns among borrowers. This non-neutrality canbe decreased by applying monetary policy more or less uniformly acrossfinancial intermediaries as would be possible, for example, through the use ofopen market operations or through uniform reserve requirement changes. It canalso be decreased by reducing the segmentation of the financial system aswould be possible, for example, through the lifting of business boundaries andregulatory distinctions between banks and selected non-banks, such as STFCs,and the encouragement of an interbank market in which both banks and selectednon-banks participate.

D. Financial Liberalization in Korea's Future

2.56 The preceding sections have described some of the structural changesthat have occurred in Korea's financial system and have discussed their impli-cations for monetary control and resource allocation. In addition to thesestructural changes the emerging monetary context features a gradual process offinancial liberalization to which the Korean government has been committedsince 1980. Under this process, a number of deregulatory steps are envisaged,of which the most important are: greater autonomy for deposit money banks tomanage their assets and liabilities via the elimination of directed creditprograms and via greater interest rate flexibility, to reflect both demand andsupply of funds as well as risk considerations for different types of loans;greater competition in the financial system through the blurring of businessboundaries among banks and nonbanks, through the relaxation of restrictions onforeign banks, through reduced barriers to entry and through the promotion ofthe domestic securities market; greater flexibility with regard to themovement of capital in and out of country, through relaxation of restrictionson direct and portfolio investment for foreigners as well as nationals andperhaps even through an eventual shift to a convertible, freely floatingexchange rate.

2.57 Pressures for Liberalization. The process of financial liberali-zation has not gone far enough in Korea and, on occasion, progress has beenreversed. Nevertheless, it remains a serious and active element in officialthinking and a clear objective of the Sixth Plan. Pressure for furtherliberalization may come from a number of sources. It is likely to bestrongest from foreign sources which may want access to the Korean financialservices market in return for having allowed access to Korea to their owngoods (and services) markets. Some pressure has been brought to bear inrecent years by the foreign banking community; this is likely to increase asdiminishing foreign-currency lending opportunities (on account of externalsurpluses) push foreign banks into desiring more domestic-currency business.Such pressure is also being exerted by the foreign manufacturer and investorcomunnity which would like greater opportunities for direct and portfolioinvestment in Korea. Finally, much pressure is being brought to bear by thegovernments of those foreign countries who are running large deficits withKorea, for freer capital and trade flows and for exchange rate flexibility.

2.58 Pre.sure to liberalize may also arise from a concern with maintain-ing price stability in the face of sustained surpluses. At present, excess

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liquidity is being controlled through the sale of BOK and Government securi-ties to nonbanks and by direct credit controls on DMB lending. The scale ofthe sterilization effort required to to cope with the anticipated externalsurpluses, however, is such that (a) reliance on domestic purchases ofGovernment securities may be inadequate (b) interest rates may be forced torise to levels seriously detrimental to price stability and to businessactivity and (c) reliance on sterilization alone may be inadequate. Theauthorities may find it necessary to (a) allow foreign purchases of Governmentsecurities denominated in the domestic currency; this would spread the burdenof sterilization across a wider bondholding population and avoid saturatingdomestic portfolios with such securities; and (b) to allow domestic residents(corporations, banks and individuals) to hold foreign assets, either throughDFI or PFI; this would reduce the need for sterilization. The upshot is thatas external surpluses grow, so will the need for greater financial liberaliza-tion in terms of relaxation of restrictions on international capital flows.

2.59 Finally, pressure for further liberalization will be maintained bywhat may be called the evolutionary momentum of a rapidly industrializingeconomy. The considerations that prompted the initiation of financialliberalization in the early 1980's continue to be relevant today and willremain so in the foreseeable future. Such considerations include the relativeinefficiency of the financial sector caused by many years of credit pricingand allocation decisions based on national policy considerations rather thanon commercial assessments of asset quality. The hazard inherent inGovernment-directed and, by implication, officially-guaranteed financing, hasled in the past to excessive risk-taking and financial indiscipline on thepart of both borrowers and lenders. In addition, the macroeconomic context ismuch more supportive of financial liberalization: inflation is no longer ashigh as it was in the late 1970s and thus no longer as disruptive of efficientfinancial intermediation now as it was then.

2.60 On balance it is likely that greater financial liberalization willbe a major element in Korea's future policy program. It is important,therefore, to consider the effects of such liberalization on the scope andconduct of monetary policy. Since the achievement of greater liberalizationwill occur in the future one cannot use Korea's own past experience forguidance on this issue. Instead one must rely on the lessons of comparativeexperience.

2.61 An idea of the changes to be anticipated may be obtained from theexperience of Japan whose monetary system twenty years ago was similar to thatof Korea's today. In the early 1970s, Japan began to liberalize its financialsector in order to accommodate changes in the flow of funds brought about bythe end of the "high growth period" of the 1950s and 1960s, help its financialinstitutions become more efficient and capable of competing in the inter-national financial system, and to cope with changes in the scale and speed ofcapital flows in and out of the country engendered by its switch to a floatingexchange rate system. Financial liberalization affected the Bank of Japan'smonetary management in several ways. The BOJ increasingly shifted to instru-ments that affect interest rates r sher than credit as an intermediatetarget. It de-emphasized direct quantitative controls on bank lending (e.g.,"window guidance") and came to rely more and more on open market operations.

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In the process of adjusting to liberalization, it has been hampered by thelack of a short-term government security and, to a lesser extent, by thenarrow holding of Government paper.

E. Recommendations for Institutional Reform

2.62 The 8OK faces new challenges in the coming years because of therapidly changing context of monetary policy. The emergence of a currentaccount surplus in 1986 and the likelihood this reflects a discrete shift inKorea's external relationship, the slow but gradual continuation of domesticfinancial liberalization, and increasing external pressure to hasten the paceof domestic reforms and to initiate international financial liberalizationhave all combined to change the context of monetary policy.

2.63 In order to cope with the new environment, it is imperative that theBOK remain committed to price stability. The experiences of the OECDcountries during the past decade have shown that a commitment to pricestability, even in the presence of shocks, is the most meaningful contributionthe monetary authority can make to economic growth and to a smooth financialliberalization process.

2.64 The description of the emerging monetary context and the assessmentof Korean monetary institutions, instruments and practices provided in thischapter, leads to an agenda of recommendations which, if adopted, would assistthe BOK in its quest for price stability in the emerging new context ofmonetary policy. While the agenda focuses on improving the flexibility ofmonetary policy, it is important to keep in mind that the recommended changeswill also contribute to a more even and consistent financial liberalizationprocess. Put differently, the majority of recommended policies would promoteprogress towards establishing an efficient, adaptable, and sound financialsystem as well minimize undesirable resource allocation biases of monetarypolicy. The recommendations are:

(a) Apply monetary control instruments equally to all the importantintermediaries in the financial system

(b) Establish art active interbank market with broad participation.

(c) Establish a competitive government securities market.

(d) UJse the Z0I discount facility exclusively as a monetary controlinstrurient and delink it from industrial policy objectives.

(e) Strengthen the role of the BOK as a guarantor of price stability.

(f) Increase tha pace cf interest rate liberalization.

2.65 Scu Applicaftion of Honel:ary Control Instruments. There is aseroug t_priir1 basis for expecting weakened and uneven monetary control inK4rea as a cofsequence of stru'tural change and liberalization in thefi.nancial sector. The rapid growth of the !BFI segment means that alreadyover zalt of tlhe deposits in the system are outside the scope of reserve

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regulations and almost half of the loans made are ntither subject to directcontrols nor controllable through discount operations. At present, only oneinstrument, the open market sale of Monetary Stabilization Bonds (MSBs), isbeing used to control the liquidity of the NBFI segment. Moreover, there isevidence that suggests that monetary restraint applied to banks is oftenpartially offset by expansion generated by some NBFIs.

2.66 One way for the monetary authority to increase the degree of mone-tary control in the present circumstances would be to extend reserve regula-tions to NBFIs such as short-term finance companies (STFCs) and savingsinstitutions. A complementary measure would be to extend such regulations toall types of deposits held in deposit money banks (DMBs) and the NBFIs notedabove. These measures can be justified on both effectiveness and equitygrounds. Uniform reserve requirements across institutions and deposit-typeseliminate the effect on the money supply of shifts in deposits amonginstitutions and maturities and thereby provide more effective control overtt.e money supply. Effectiveness of control is also enhanced by bringing alltypes of deposit Liabilities under uniform reserve requirements. Furthermore,now that STFC's and savings institutions have become well-established,fairness requires that their regulatory advantages vis-a-vis DMBs be reduced.

2.67 The present system has its advantages. It is likely that a largeramount of the money supply is being absorbed through the sale of MSB's toNBFIs than would be possible through the use of reasonable RRRs. This isbecause RRRs could not be applied to such institutions as insurance companiesand very small mutual credit associations while MSBs are being sold to them.Also, each institution buys a larger amount because the loss associated withthe purchase of MSBs is much smaller than the loss associated with havingRRRs. Given that the effective lending rate is about 16% this is theopportunity cost of RRRs which currently carry no interest; on the other hand,the opprounity cost of MSBs is about 3X which constitutes the differencebetween the interest rate which is paid by the BOK (about 13X) and the rate atwhich the secondary market will buy the MSB from the NBFI about (16%). It ispossible that imposing RRRs on NBFIs could provoke resistance and could revivethe curb market.

2.68 Nevertheless, the virtues of the present system could be retained ina system that does not discriminate among type of financial intermediary asmuch as the present one does. For example, both banks and nonbanks could berequired to hold MSBs and both could be required to hold specific reserveratios. The opportunity cost to the primary dealers/buyers/underwriters couldbe lowered by raising the yield on MSBs so that it is closer to the secondarymarket yield. This would raise the cost for government but would reflect thesocial opportunity cost of containing the monetary pressures generated by anexternal surplus. In fact, this cost provides a signal to government/societyregarding the optimality of a given level of external surplus. Furthermore,interest rate flexibility is the best way of building money markets of allkinds. To the extent that the purchases of MSBs are involuntary at present,no progress is currently being made towards the fostering of efficient openmarket operations.

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2.69 Interbank Market. There does not yet exist an active and flexibleinterbank market in Korea despite official claims that such a market existsand has been the focus of recent liberalization efforts. Demand and supplyconditions in the interbank market continue to be tightly regulated.

2.70 An interbank market has four benefits for flexible monetarypolicy. First, it would provide a sensitive market closely "located" in aneconomic sense to the BOK's policy instruments that would spread the effectsof policy changes to all participants to the interbank market irrespective ofwhether they were net demanders and net suppliers of funds. Second, it wouldprovide an operating environment for the BOK to obtain immediate informationabout pressures in the financial system. Third, it would provide a liquidmarket for participants to manage risk and absorb shocks. Fourth, a billcomponent segment of the interbank market for longer term borrowing wouldprovide the BOK with an additional open market policy instrument.

2.71 The evolution of BOJ policy during the past several decades suggeststhat even in the context of a highly regulated financial system, an interbankmarket provides an important link between the policy instruments of thecentral bank and the ultimate policy targets. Actions taken to influence theinterbank rate were quickly transmitted to all participants in the market andin turn, the effects were transmitted to the real sector in the form ofreduced credit availability and increased cost of credit. The interbankmarket continues to be an important part of the tran!Wssion of monetarypolicy in Japan as it has been in the United States._

2.72 It might be emphasized here that it is not necessary for theinterbank market to be a "large" provider of funds relative to the bankingsystem's assets in order for it to play an effective role in monetary con-trol. It merely has to provide a quick and efficient forum for portfolioadjustments for banks (and other financial intermediaries) in response todemand and supply shocks to the flow of funds. In both Japan and the US, forexample, interbank transactions typically amount to about 5X of bank assets.This level is enough, however, to enable this market to serve as an importantforum for portfolio adjustment and an integral mechanism for the efficienttransmission of monetary policy.

2.73 Nor does stability in participation patterns reduce the potentialeffectiveness of the interbank market. In Japan, the city banks have beenconsistent net demanders of funds from the interbank market while other banks(mostly regional banks) and other private financial institutions have beenconsistent net suppliers of funds. It is very likely that a similar patternwill emerge in the Korean context if an active interbank market were to be

28/ Nevertheless, Japan's government securities market is still undevelopedby US standards. Activity in the short-term component is low because taxconsiderations limit participation only to financial institutions. Theplacement of medium and long-term debt is influenced by a cartel-likearrangement among major government bond dealers. Also, foreign financialinstitutions have not yet been permitted equal access to the market.

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promoted. But persistent excess demand or excess supply situations ofparticipating units need not stymie market development. The important thingis to ensure broad participation. In the Korean case this would involveallowing NBFI's to play a more active and substantial role than is presentlythe case, to abolish or significantly relax quantitative limits on interbanktransactions, to permit interest rates to clear this market and to influenceinterest rates as necessary through open market operations rather than throughdirect controls.

2.74 Government Securities Market. An active and open governmentsecurities market with a broad maturity spectrum would assume major importancefor the transmission of monetary policy. It would spread the effects ofmonetary policy actions in a continuous manner throughout the financial andreal sectors in three aspects. First, government securities would be widelyheld by financial and nonfinancial sectors ensuring a widespread impact ofchanges in monetary policy. Second, an active government securities marketwould provide the foundation for general interest rate determination by makingavailable a flexible default-free short-term interest rate. Third, governmentsecurities iauld provide an important secondary reserve asset for financialinstitutions and thus make it easiE to them to make portfolio adjustments inthe face of changes in BOK policy. They would play a similar but lessimportant role for other market participants.

2.75 Open market operations are the most powerful and flexible instrumentof monetary policy and provide the basis for an even and rapid distribution ofthe effects of monetary policy especially in the context of increasinglyflexible and competitive financial s ructures. These advantages however,depend on the existence of a suitable open market instrument. Technically,open market operations can be conducted in a wide range of assets; however,the open market asset should possess four characteristics to ensure even,continuous, and nondisruptive open market operations. First, the asset mustbe traded in a broad and active market with wide participation; second, theasset must play a major role in the portfolio decisions of marketparticipants; third, the interest rate must play an important role in generalinterest rate determination; and fourth, the monetary authority should not beconstrained in conducting flexible open market buying and sellingoperations. A wide and broad government securities market best meets theserequirements and the experience of the United States has shown that such amarket rapidly assumes major importance irh the transmission of monetarypolicy.

2.76 Steps taken recently to broaden the base of purchasers (viacorporate trust accounts) and underwriters (via the Bond Management Fund) arein the right direction. Among further appropriate steps would be the

29/ Quantitative studies of optimal portfolios typically show that suchportfolios would hold riskless short-term assets, such as Treasury billsin the US. A recent study for Korea shows that national portfolioscontaining such an asset dominate portfolios without it (Anckonie andChi, 1986).

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introduction of securities covering a wide range of maturities and aimed at awide range of investors (individuals, banks, NBFIs and institutions) so as toincrease the holding of Government paper and avoid saturating portfolios.These securities must be offered at competitive market-based rates so as notto assume the character of a tax instrument and discourage wide holding.

2.77 The establishment of a government securities market is constrainedby the lack of government deficits in recent years; however, there does exista large volume of outstanding government loans on the asset side of the BOK'sbalance sheet which could be converted to open market instruments. While theamounts would not be sufficient to eliminate the need for MSBs at present, theBOK would be in a position to shift to an open market instrument that would befar more flexible and allow a far more even distribution of the effects ofmonetary policy than currently possible.

2.78 Re-orientation of Rediscount Policy. The discount window at the BOKplays a dual role as a general monetary policy instrument and as a method toprovide subsidized credit to favored sectors of the economy and maintain theviability of DMBs. In the past the industrial policy function of rediscountoperations has often prevailed over the monetary function. While this mayhave been necessary upon some occasions and beneficial upon others,maintaining duality of function now appears to be more and nore costly fromboth the industrial efficiency and monetary control standpoints.

2.79 Government should consider using the rediscount facility exclusivelyfor monetary control objectives from now on. Over the foreseable future thiswould mean deploying the rediscount instrument to achieve monetaryrestraint. The presently comfortable liquidity situation in much of thecorporate sector means that output and employment will not be severelyaffected by a reduction of credit facilities. Profitability might be affectedbut, to the extent that present discount operations confer subsidies onborrowers, this may not be an undesirable outcome from an efficiency point ofview. Indeed, the sharp reduction of export financing credit facilitiesundertaken this year is a step in the right direction both from an efficiencypoint of view and from the point of view of reducing the external surplus andthereby reducing the required level of sterilization.

2.80 Also, progressively delinking discount operations from industrialpolicy objectives would be consistent with Government's intention of with-drawing from active intervention in the economy. Of course, a careful balancehas to be maintained between these desirable outcomes and *he continuing needto sustain the financial health of conmercial banks. It % uld seem, however,that policy makers have erred on the side of excessive concern for the bankingsystem in the past, with the unintended result that the system has become evermore dependent on subsidies. To the extent that the chief impediment to amore efficient and self-sustaining commercial banking system is the problem ofnon-performing loans, Government should devote increased attention to thesearch for new solutions to this problemn and not allow its debilitatingeffects to persist and act as a drag upon financial sector development.

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2.81 Autonomy of Monetary Policy. Evidence strongly suggests thatmonetary authorities can make the greatest contribution to economic andfinancial stability when they remain committed to stable and low inflationrates even in the face of external shocks, changes in established flow of fundpatterns, growth of government deficits, and external political pressure. Inaddition, the monetary authority should pursue price stability in the contextof evenly dispersed monetary policy effects and minimal resourcedistributional effects. Should other policy makers decide to direct resourcesto a specific sector of economy, tax and expenditure policies are moreefficient. Monetary policy and resource allocation policy are two separateand distinct roles for government.

2.82 Formal independence from government does not ensure stable monetarypolicy. The Federal Reserve System is one of the most formally independentcencral banks in the world; however, it failed to provide a stable financialenvironment during the 1970s and in the view of a number of observers, hascontinued to be a less than stabilizing influence on the United Stateseconomy. In contrast, the BOJ is clearly less independent than the FederalReserve and yet, has achieved a degree of monetary and price stability thatcompares favorably with any economy in the world. Thus formal independencefrom government is neither a sufficient nor a necessary requirement the mone-tary authority to provide a stable financial environment; therefore, there islittle reason to recommend a particular structure of the BOK. There is,however, considerable room for improving the independence of Korean monetarypolicy.

2.83 There are three suggestions that if adopted, would improve theability of the BOK to conduct monetary policy in a more flexible and effectivemanner. First, Government should cease using monetary policy to direct creditto specific sectors of the economy. Second, the banking system should bereorganized to improve its financial condition so that the BOK is not requiredto constrain general price stability policies by efforts to maintainfinancially weak banks. Third, Government should avoid direct loanrelationships with the BOK in the event that government deficits reemerge inthe future.

2.84 Interest Rate Liberalization. The regulated nature of Korea'sinterest rate structure forces the effects of BOK policy to be reflectedprimarily by quantity adjustments rather than price adjustments. A commit-ment to increase the pace of interest rate liberalization would significantlycontribute to a more effective monetary policy in two respects. First,flexible interest rates in both indirect and direct markets bring the marketstogether via arbitrage transactions and hence, monetary policy effects in onemarket will be rapidly and smoothly transmitted to other markets throughoutthe financial system. Second, flexible interest rates throughout thefinancial system will permit the effects of monetary policy to occur withsmaller changes in interest rates in any specific market. These considera-tions are made all the more important by the fact that the interest rate-expenditure channel of monetary policy becomes more important as liberaliza-tion progresses.

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2.85 Interest rate liberalization could be conducted in three steps. Inthe first step, interest rates applicable to comparable-maturity andequivalent-risk deposits and loans would be equalized across financialintermediaries. The integration of such interest rates would help stabilizethe structure of the financial system as well as reduce segmentation. Inaddition, it would promote the development of an interbank market. In thesecond step, floors or downside limits on deposit and lending rates should beremoved and only a uniform ceiling should be left in place. Financialintermediaries should be set free to establish rate bands in accordance withrisk and maturity characteristics of loans and deposits and with degrees ofefficiency of individual intermediaries. In the third stage, ceilings on suchinterest rate bands should also be lifted and a full liberalization ofinterest rates achieved. It is clear that there presently exists a uniqueopportunity for Korea to accelerate the interest rate liberalizationprocess: the economy is booming, firms are flush with cash and financialintermediaries are stronger now than at any other time in the last fiveyears. The case for liberalizing interest rates was always strong; now it hasbecome overwhelming.

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III. MONETARY MANAGEMENT: SELECTED MACROECONOMIC ISSUES

3.1 There are two aspects to running a successful and sustainedsterilization program. One aspect is the technical one concerning mainly theavailability of adequate monetary instruments, controls and channels oftransmission. This aspect has been dealt with elsewhere (see Chapter 2). Theother aspect is the macroeconomic one and this concerns the appropriateness ofthe magnitude of sterilization aimed at, the interplay of policies that can bedeployed to achieve this objective, and the overall consequences ofsterilization efforts.

3.2 This chapter provides a discussion of the macroeconomic aspect ofsterilization. Five issues are considered. The first is the consequence forprice stability of an uncontrolled expansion of the money supply generated bylarge external surpluses. It is noted that the potential for inflation is solarge under the anticipated magnitude of Korea's external surpluses that asystematic policy of monetary targeting must be continued.

3.3 The second issue arises from the first in that, having noted thenecessity of monetary targeting, it is important to consider the choice of anappropriate monetary aggregate to serve as an indicator of the success orfailure of the targeting effort. Statistical and other considerations suggestthat both the narrowest and the broadest aggregates are more appropriate inKorea's case than intermediate aggregates such as M2.

3.4 The third and fourth issues consist of the consequences of asustained sterilization program for (a) domestic money markets and (b) govern-ment fiscal priorities. Under certain conditicns, such a program can disruptmoney markets and fiscal priorities by leading to very high domestic interestrates and a high internal debt-servicing burden. In the Korean case thismight happen if the sterilization program continues at its present scale andrestrictions are maintained on the ability of domestic residents to holdforeign financial assets. The relaxation of restrictions on capital outflowsand the issue of foreign-currency-denominated sterilization instruments (todomestic residents) would help reduce such disruption.

3.5 The possibility remains that such measures may not be sufficient toavoid significant macroeconomic difficulties in the form of rising inflation,high interest rates and a rising fiscal burden. The fifth issue discussed,therefore, is that of reducing the magnitude of the sterilization target viathe repayment of outstanding foreign debt. Other ways of accomplishing this,such as by reducing the size of external surpluses directly through trade andexchange rate measures, serve more than a monetary purpose and are consideredin later chapters on trade management.

A. Monetary Targeting

3.6 Korea has been publishing monetary targets since 1957 and pursuingthem in a dedicated fashion since around 1979. The practice was adopted inearnest in 1979 as one of the means to control inflation which had grown at ahigh and variable rate through the 1970's. In doing this Korea was following

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the lead of major industrial countries who had adopted monetary targetingafter 3imilar experience with inflation in the wake of the first oil shock in1973.,.I Now, after a decade or so, the practice of rigid targeting isfalling out of favor in many industrial countries for primarily two reasons.First, inflation has been substantially reduced in most of these economies andhence the need to target and fine-tune monetary aggregates is no longer quiteas pressing. Second, the stability of the relationship between money andnominal GNP which formed the technical basis for targeting has been disruptedby financial deregulation and innovations as well as by supply-related priceshocks. Hybrid monetary instruments which serve both portfolio andtransaction purposes (such as interest bearing checking deposits) have becomeincreasingly important components of monetary aggregates. Empirical studiesof the dema'nd for money in several different, though linked, economies such asthe UK, USA, and Germany have shown that the estimated parameters are notrobust: they assume different values depending on the sample period and arevery sensitive to model structure. This shows essentially that the behaviorof the relevant economic agents in the new environment of deregulation andgreater choice among financial assets is not as yet well understood. A prac-tical outcome of this uncertainty is that monetary targets are missed withwider margins and greater frequency than before. Some monetary authoritieshave responded by setting broader targets and reacting flexibly toovershooting and undershooting while others have de-emphasized monetarytargeting in relation'to other guistes to policy such as the exchange rate.

3.7 These issues find an echo in Korea's case also. Thus the questionwhether or not to target is not merely a rhetorical one. For example, thehigh inflation of the 1970s that prompted the adoption of targeting nowappears to have been conquered. Between 1980 and 1985 Korea's inflation rate(GNP deflator) fell from 28% to 4.5%; it has stayed at or under this levelsince. Thus the urgency attached to monetary control of inflation may beexpected to have declined. Moreover, greater leeway is now available forovershooting monetary targets.

3.8 Financial deregulation and innovation has also been evident in Koreaduring the 1980s albeit to a much lesser extent than in the major industrialeconomies. Broad money, featuring such financial instruments as interest-bearing and negotiable certificates of deposit, has grown much faster than

30/ While examples of targeting can be found in earlier periods, it was onlyin the 1970s that such practices became common in the OECD countries.Thus, the Bundesbank announced a monetary target in 1974, the SwissNational Bank in 1975, and the Dutch and English central banks in 1976.As far as the US is concerned, the Federal Reserve has been reportingmonetary targets since 1975 but took up implementation in earnest after ahistoric meeting of the Federal Open Market Committee in October 1979 atwhich it was decided that henceforth the money supply rather thaninterbank interest rates would be of primary concern and bank reserveswould be controlled more directly. Information regarding thecircumstances surrounding these respective decisions is available inCourakis (1981).

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narrow money and non-bank financial institutions (NBFIs), which are a princi-pal source of such instruments, have grown much faster than traditionalcommercial banks. The substantial structural change that has occurred withrespect to the relative roles of banks and nonbanks has already beendocumented (see Table 2.1). The growth rates of different monetary aggregatesare shown in Table 3.1 which also shows how the financial sector has grownrelative to GNP.

Table 3.1: FINANCIAL SECTOR GROWTH

1980 1983 1984 1985 1986 1987

Rates of changeM1 16 17 1 11 17 15K2 27 15 8 16 18 19M3 /a 33 22 20 21 26 31

PercentagesM2/CNP 34 39 37 39 40 41M3/GNP 43 64 68 75 82 93Bond/CNP /b 4 7 8 10 10 10FA/GNP /c 238 308 326 351 359 379M2/M3 70 61 55 52 49 45

/a M3 is defined as the sum of M2 plus deposits at nonbank financialinstitutions and commercial bills sold and certificates of deposits anddebentures issued by deposit money banks.

/b Value of listed corporate bonds.Th FA refers to total financial assets of the economy which include assets

of financial institutions but exclude foreign assets and trade credit.

Source: The Bank of Korea, Economic Statistics Yearbook, various issues.

3.9 These developments caution against uncritical and inflexible pursuitof monetary targets. Nevertheless, a preview of Korea's future macroeconomicevolution suggests that continued monetary targeting is essential to theconduct of sound policy. The chief reason for this lies in Korea's presentand prospective situation of substantial external imbalance, a situation thatcould easily disrupt the price stability and exchange rate competitivenessthat has been achieved in recent years. Korea has experienced a substantialcurrent account surplus since mid-1986 (approximately $10 billion to mid-1987)and, under the most likely scenario for the near future, should continue torack up surpluses at the rate of $5 billion per year through 1990. Thisexternal disequilibrium has its positive aspects, of course. But it is solarge that it constitutes the principal threat to price stability over thenext few years. Of course, measures could be undertaken to reduce theanticipated surpluses and thereby reduce the threat to internal macroeconomic

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balance. In the absence of measures of sufficient potency, however, themonetary authorities in Korea have no choice but to exercise vigilance andrestraint in the form of targeting.

3.10 Another reason to continue monetary,targeting is to benefit fromwhat is known as the "announcement" effect., Targeting provides economicagents with information regarding the intentions of the monetary authorities.As such it influences public expectations in desirable directions thereby mak-ing certain policy objectives easier to achieve. Targeting was used vigorous-ly in the early 198'Js in the successful campaign for stabilization and, in theprocess, the monetary authorities have built up a certain amount of credibili-ty as inflation-fighters. Abandoning targeting now may erode this credibilityand may raise inftationary expectations. Given the scale of the potentialliquidity expansi.on faced, such a step may be disruptive for its psychologicaleffects even if it is not inherently risky as far as short-run inflationmanagement is concerned. At this point it may also be useful to note paren-thetically that the method chosen to reach a given target may have "announce-ment" effects of its own which may reinforce or offset the announcement effectof the target dependygg.on the public-'s perception of the method's effective-ness.

3.11 Finally, continued targeting may be useful in a political sense tothe extent that it restrains the growth of the public sector. Once targetsare announced, public sector borrowing may be limited by appealing to thenecessity of observing the targets. It has been found that the presence of

31/ The announcement effect arises because of the critical role played byinflationary expectations in determining actual inflation. As long asthe public perceives inflation to be a monetary phenomenon and developsexpectations based on this belief, the authorities have to take theannouncement effect of monetary targets seriously even though specialistsmay quibble about the true relationship between money supply andinflation. By announcing targets, the authorities provide a generalframework for expectations of inflation, a framework that may be of helpin dampening destabilizing speculation. Opinion is by no meansunanimous, however, as far as the theory of announcement effects isconcerned. Considerable variance exists in the strategies of differentcountries. For example, the US Federal Reserve prefers to announce four,quarterly revisable target ranges while the German Bundesbank prefers tostick to a single valued yearly target.

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monetary targets often constrains political interests to keep pubip sectorexpenditures and borrowing within macroeconomically sound limits._

3.12 The current and expected state of substantial external disequili-brium makes targeting a necessity. However, the BOK has greater flexibilitynow than it has had historically. Now that inflation is at a low level, andinflationary expectations seemingly dormant, the BOK can afford to set long-run targets and ignore short-run deviations from the targeted path. In addi-tion, it can afford to set broader targets rather than narrow and preciseones. Indeed, the proliferation of hybrid monetary instruments in recentyears and the associated behavioral instability of money demand has made itincreasingly difficult to hit narrowly defined targets. Such has been theexperience of a large number of developed economies and such is likely to beincreasingly true for Korea in the future. Given the increased underlyingvariance of monetary aggregates it may be counterproductive to attempt to hitvery narrowly defined targets. In view of this, the BOK would do well toadopt a range rather than a rigid number as the appropriate target. The BOKshould also consider implementing monetary targets more flexibly. Forexample, it need not insist that commercial banks meet a monthly target forcredit expansion as part of its monetary control strategy. Instead, bankscould be allowed to adjust their transactions over a longer period of time,say a six monthly period, as long as this is consistent with the annualmonetary target. Finally targets could be set in terms of averages ratherthan precise rates of growth linked to specific dates.

B. What to Target: Choice of Indicators

3.13 Having determined that external imbalance is likely to generatesubstantial monetary expansion which, if unchecked, is likely to generateinflation and instability in the domestic financial system, we are lednaturally to the question of the choice of indicators: which monetaryaggregate should the monetary authorities attempt to control? A large numberof such aggregates is available as the following table indicates:

32/ German and British experiences may be cited in support of the validity ofthe "presentational" role of targeting. In the German case it has beenargued that the formulation of monetary targets has helped to form asocial consenus among important groups such as labor unions, bankers,corporate managers and politicians (see H. Schlesinger, 1979). In theBritish case also it has been suggested that the public sector borrowingrequirement can be made to conform to inflation and growth objectivesdefined by monetary targets (see J. Salop, 1987).

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Table 3.2: MONETARY UgDICATORS

MC: CurrencyMO: Currency and Reserve deposits of Deposit Money BanksMI: MO + Demand deposits at DMB'sM2: Ml + Time and Savings Deposits at DMB'sN2CD: M2 + Certificates of Deposits at DMB's and NBFI's143: M2 + NBFI deposits and Debentures issued + Commercial Bills + CDs

Different countries have focussed on different aggregates at different pointsin time. It would appear that different indicators are best for differentpurposes and in different economy-specific contexts. A reasonable way toapproach the problem then is to evaluate each of the indicators in terms ofcertain generally desirable properties while keeping in mind specific aspectsof the Korean situation.

3.14 There are at least two properties that a monetary indicator mustpossess in order to be a suitable candidate for targeting: effectiveness andcontrollability. Effectiveness refers to the strength and stability of theindicator's link to the level of economic activity; there is little point intargeting an aggregate that has only a weak and unpredictable effect on theultimate goal. Controllability refers to the degree to which the aggregatecan be manipulated by instruments under Government control, such as openmarket operations. Typically, these instruments affect other intermediatevariables, such as interest rates or the general price level, which in turninfluence financial intermediary, consumer and corporate behavior in ways thatalter the level of the aggregate in question. Clearly there ;s little pointin targeting an aggregate that is only weakly and unpredictably linked topolicy levers.

3.15 Effectiveness. The main premise underlying targeting is that thelevel of economic activity can thereby be influenced in desirable directions.On this view, the more effective the link between a monetary aggregate andeconomic activity the greater should be the preference for such an aggregateas a target for monetary policy. In principle, this is a positive issue whichmay be adjudicated by empirical investigation. In practice, difficultiesarise in defining appropriate measures of economic activity and in comparingresults across different periods in time.

3.16 Our approach in evaluating the Korean data has been to examinie thestatistical relationship between various monetary aggregates and threedifferent measures of economic activity: nominal GNP growth, real absorption(C+1+G), and inflation. We also separate the data into two periods, 1974-81and 1979-86, so as to be able to capture the effects, if any, of the majoreconomic reversals and policy reorientation of the 1979-81 period. Thefollowing are the principal results of the empirical analysis as shown inTable 3.3:

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(a) There is a clear tendency for the narrowest aggregates (MC, MO) tohave the strongest statistical relationship with nominal GNP, realabsorption and inflation especially when results for the entireperiod 1974-86 are considered.

(b) There is a clear tendency for the broader aggregates (M2CD, M3) todevelop stronger statistical relationships with the above measuresof economic activity in the latter period (1979-86) as compared withthe earlier period (1974-81).

(c) If only the latter period is considered, the broadest aggregateshave as strong a statistical relationship as do the narrowestaggregates. There is little statistical basis to choose between MCand M2CD, the two most relevant indicators.

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Table 3. : EFFECflIVEMS OF ALTERATIVE MONETARY INDICATORS

samiple pedodiiMonetary aggregate f8 aggre 19g 79-

A. Correlation CGefficient Between Nominal GNP Grouth and Monetary Growth /a

NC 0.82 0.57 0.84*MO C.77 0.73 0.64Hm 0.66 0.71 0.40HZ 0.73 0.48 0.77M2CD 0.73 - 0.78*M3 0.61 0.33 0.75

B. "Goodness of Fit" of Domestic Absorptio.' Function /b

MC 0.55 0.57 0.62MO 0.60 0.65 0.63Ml 0.51 0.63 0.51M2 0.53 0.61 0.67*M2CD 0.53 0.61 0.69*M3 0.43 0.54 Q 6i

C. "Goodness of Fit" of Inflation Function /b

MC 0.86 0.60 0.86*MO 0.65 0.60 0.46ml 0.82 0.70 0.74H2 0.84 0.60 0.8b*M2CD 0.83 0.60 0.86*M3 0.74 0.60 0.83

Notes7iGrowth rates of nominal GNP and money stock are measured over the same

quarter of the previous year. The coefficients reported are the highestobtained using a variety of lag specifications. In most cases, a lag oftwo quarters provided the best results.

/b The "goodness of fit" criterion used here is the conventional R-squaredstatistic: a value closer to 1 indicates a better fit. The money stockvariables used are all five-quarter moving averages.

The equations estimated have the general form:

(B) AlnYd ao + a,Aln (100 + r) + a ln (100 + Pe)° + a3Aln (Yd -1) + a4.P;L (Aln M/P)

(C) AlnP bo + b 1 Aln (100 + r) + b2 ln (100 + Pe)+ b3 .PDH (AlnM/Y)

where a indicates change over same quarter of previous year;Yd = C + I + C;r - curb market interest ratePe - expected inflationM - money stock

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3.17 Several explanations can be advanced to explain the above pattern ofrelationships. The high predictive value for MC may be due to the fact thatthis aggregate reflects the demand for money for transactions purposes, ademand that typically bears a fixed proportional relationship to the level ofeconomic activity and that is typically not influenced substantially byvariations in such factors as interest rates or by financial innovations suchas new types of depository instruments. The motivation underlying thetransactions demand for money is to have enough cash on hand to meet payrolland other short-term needs. Historically, this aggregate has been lessaffected by policy because other aggregates have been considered morerelevant; as a result, it has been far less subject to policy-inducedvariations which would weaken or obscure its statistical relationship withnominal GNP and inflation. For example, it appears to have & stronger andstabler relationship with these indicators of economic activity than even MObecause the latter has often been subject to large fluctuations on account ofreserve requirement changes, especially before 1981.

3.18 The increasing statistical strength over time of the broaderaggregates may be explained by the fact that such liability types ascertificates of deposit, and nonbank commercial paper and debentures, arelargely a product of the last five years or so. The liabilities that comprisethe broader aggregates are more interest-sensitive than the ones that enterthe narrower aggregates. The reorientation of financial policy in 1981-82 toput sustained emphasis on achieving high real rates of return on financialinstruments resulted in much faster growth of M3 in comparison to narroweraggregates (see Table 3.1). As these instruments have grown in popularity andfinancial importance, they have apparently begun to exercise greater influenceon the overall level of economic activity.

3.19 On the strength of these findings one can tentatively conclude thatthe two broadest monetary aggregates (M2CD and M3) or the two narrowest ones(MC, MO) are to be preferred as indicators (or predictors) of future economicactivity. Among the indicators showing most effectiveness, the order ofsuitability might well be taken to be M2CD, MC on the grounds that the broaderaggregate is becoming increasingly more important. Intermediate aggregatessuch as Ml or M2 may be inappropriate indicators for policy because of theirweakening statistical relationship with various measures of the level ofeconomic activity. Indeed, as Table 3.4 indicates, Korea has not been verysuccessful in achieving M2 targets in practice. During 1985-87 theautho 3iies have found it necessary to revise M2 targets several times eachyear._

33/ The misses shown in Table 3.4 do not necessarily reflect technicalproblems of control. Sometimes a miss is deliberately allowed so as toaccorunodate other policy concerns. In 1985, for example, an unexpectedslowdown of the economy necessitated monetary expansion. The monetaryauthorities often have to balance the targeting objective against otherobjectives such as interest rate, employment and exchange rate stability.

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Table 3.4: MONEY SUPPLY TARGETS IN KOREA, 1979-1987

Year 1M2 Target Actual

1979 25.0% 24.6%1980 20.0 26.91981 25.0 25.01982 20.0 - 22.0 27.01983 18.0 - 20.0 15.21984 11.0 - 13.0 7.71985 (a) 9.5 - 12.0 - 14.0 15.61986 (b) 12.0 - 14.0 - 16.0 - 18.0 18.41987 (b) 15.0 - 18.0 - 20.0 20.01988 18.0 n.a.

Note: (a) Adjusted upward in second half of year because of slower thanexpected economic growth. (b) Adjusted upward because of rapidgrowth in real sector resulting from trade surplus.

Source: Bank of Korea.

3.20 The Korean results conform generally with international evidence. Areview of the latter shows that the broadest monetary aggregate, M3, istypically to be preferred to such aggregates as Ml and M2 on the grounds ofstability and effectiveness. At the same time, a narrow aggregate such as thecentral bank money stock (MO), often does better or as well on these groundsas M3. Thus, according to the international evidence, the appropriate choiceis between MO and M3; Ml and K2 are generally found to be unreliableindicators. Given this choice, some monetary authorities, such as theBundesbank and the Swiss National Bank, choose to 3 rget MO rather than M3 fortwo reasons: controllability and signal clarity.3

3.21 Controllability. Controllability refers to the degree to which themonetary authorities can control the size and movement of the monetaryaggregate in question. Generally speaking, the narrower the aggregate themore subject it is to central bank control. The Bundesbank has generallytargeted MO on the basis that it knows how to come reasonably close to

34/ As H. Bockelmann, a Director of the Deutsche Burdesbank put it in 1981:"our preference for central bank money (MO) is largely due to the factthat it is less prone to purely interest-rate-induced shifts and can beassumed to reflect more accurately the underlying trend of monetarydevelopments. In addition, it highlights the responsibility of thecentral bank for monetary developments as it includes the elements oftotal money supply which are actually supplied by the central bank."(Bockelmann, 1981.)

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announced targets for MO but is not very confident about hitting the broadertargets accurately. Such lack of confidence arises largely from the fact thatthe broader aggregates are subject to a host of factors such as bank behavior,asset preference shifts and, in particular, interest differential changes.Such sensitivity generally makes the behavior of the aggregate more unstable;this instability may indeed be a cause of the weak and volatile link of theindicator to economic activiLy that has been noted earlier. Unstableindicators and indicators sensitive to a large number of factors beyond thecontrol of the central bank make the bank's targeting job difficult.

3.22 Controllability has also been a major criterion guiding choice ofindicator in BOK practice. Indeed, since the Korean monetary authorities havesignificant control over interest rates as well as the behavior of financialintermediaries, it is thought that even such broad aggregates as M2 aresubstantially controllable. Hence the present emphasis on M2 targeting by theBOK. However, the empirical results described earlier suggest that M2 is notlinked to economic activity in as effective or stable a manner as broaderaggregates such as M2CD and M3. For Korea, therefore, a tradeoff might existbetween controllability and effectiveness.

3.23 Signal Clarity. This property of a monetary aggregate indicates thedegree to which overshooting or undershooting a target based on it providesclear signals for policy. Generally speaking, the narrower the target theclearer the signal from a miss. For example, if M1 is growing faster than itstargeted rate, is it quite clear that this must be due to a greater thananticipated increase in the level of economic activity or a lower than antici-pated level of interest rates. Both of these possibilities suggest that theproper course for policy is to tighten monetary policy and bring about higherinterest rates so as to prevent the expansion in economic activity frombecoming inflationary. On the other hand, if a broad aggregate like M3 isfound to be overshooting, this could be due to either higher or lower thananticipated interest rates. For example, higher interest rates on interest-bearing instruments (such as CD's) relative to non-interest-bearing instru-ments (such as demand deposits) would increase the demand for former andreduce the demand for the latter; the net effect could well be positive inwhich case M3 would increase. Indeed, the greater the proportion of interest-bearing instruments in M3 the greater the likelihood that an increase ininterest rates will increase M3. But, if so, it is not clear that a rise inM3 calls unambiguously for tighter monetary policy and higher interest rates;such a policy response would be counterproductive. It is in this sense thatbroad aggregates sometimes provide unclear signals for policy.

3.24 Having said this it should also be noted that the problem of signalclarity may not be very important in the Korean context. This is because themonetary authorities control, to a large extent, both interest rates and bankbehavior. In the formal financial market, therefore, interest rates areunlikely to rise if the authorities do not wish them to. Nor can banksundertake independent liquidity expansion in the face of announced tightermonetary policy. To be sure interest rates and liquidity may increase in theinformal (curb) market as a result of contractionary policy applied in theformal sector, but since this market is small relative to the formal market(comprising banks as well as NBFIs) the effect on economic activity,

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especially prices, is likely to be small.351 Greater concern on this scoremight arise from the behavior of STFCs. As already indicated, these financialintermediaries are not as comprehensively controlled and regulated by theauthorities as are DMBs and have, upon occasion, behaved in ways thatpartially offset the thrust of official monetary policy. For example,liquidity originating in STFCs has been growing at a much higher rate thanthat originating in banks since 1986, thereby ameliorating the impact of theauthorities' attempts to maintain a tight monetary stance. Now that STFCsaccount for a substantial fraction of total liquidity, their behavior inresponse to monetary regulations and policies merits attention not only fromthe point of view of control but also from that of signal clarity.

3.25 Indeed, this may be a general consequence of greater liberalization.As interest rates in the formal market are decontrolled and banks and non-banks are given more autonomy, the issue of signal clarity with respect to thebehavior of alternative monetary aggregates could become empiricallyimportant.

3.26 Implications for Financial Structure. Finally, the choice ofindicators may have implications for the evolution of the financial system ifdifferent types of intermediaries are responsible (by regulation) for issuingdifferent types of liabilities. For example, if banks are prohibited fromissuing CD's while non-banks are prohibited from taking direct customerdeposits, the targeting of any aggregate from MO to M2 would set a limit onthe growth of banks but not on that of non-banks. In such a situation non-banks would grow faster than banks; if such monetary restraint is applied overa long period it could lead eventually to a noticeable change in financialstructure and a possible weakening both of monetary control and monetarypolicy effectiveness. The appropriate policy might be to provide parity ofregulatory treatment across banks and non-banks as far as asset and liabilitymanagement is concerned. If such a step cannot be taken then choosing thebroader aggregate, which includes liabilities issued by noni-banks, wouldappear to be desirable.

3.27 Conclusions. Some tentative conclusions can be arrived at on thebasis of both international and Korean evidence:

(a) If controllability is considered important then MC should betargeted; if the effectiveness of the link with the level ofeconomic activity is considered important, then M2CD should bepreferred.

(b) To the extent that both criteria are important the preferablestrategy might be to target both indicators but to initiate policyactions only if both are missed on the same side. Such a strategyis also recommended by the fact that reliance on one indicator alonecould be misleading. The narrowest and the broadest measures

35/ Some evidence to the effect that the curb market has become very smallrelative to the overall financial sector is provided by recent surveys.

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contain different kinds of information. Both sets of informationmay be useful, along with other data, in moving towards macro goalsand hence both should be monitored and flexibly targeted.

C. Macroeconomic Effects of Sterilization

3.28 Under certain conditions, a sustained sterilization program can havedisruptive consequences for domestic money markets and fiscal priorities.Money market disruption occurs when domestic interest rates rise to such ahigh level as to have a significantly adverse impact on investment and output.Fiscal priorities can be disturbed if the interest payment burden associatedwith sterilization dislodges or significantly reduces planned budget alloca-tion. The main reason why domestic interest rates could rise to disruptivelevels is the existence of exchange controls which prevent cross-bordercapital flows from equalizing domestic and international interest rates.

3.29 Capital Mobility, Exchange Controls and Sterilization. A currentaccount surplus raises financial wealth. For the wealth increase not toaffect money market equilibrium, the nominal stock of money must go up toaccommodate the higher demand for real money balances at given prices. Underfixed exchange rates and perfect capital mobility, the money supply isendogenous: as the central bank intervenes to peg the exchange rate, themoney stock goes up by an amount just enough to preserve money marketequilibrium. There is no need for the central bank to accompany its foreignexchange intervention with a parallel open market operation. What is doingthe job for the central bank ig,the condition of interest rate parity thatdrives private capital flows ',- This channel does not operate in thepresence of exchange controls, because exchange controls sever the linkbetween domestic and foreign interest rates. If international capital flowsare ruled out, in order to keep equilibrium in the money market, the central

36/ A fuller explanation of how capital mobility dampens the impact of anexternal surplus on domestic money market conditions would focus on threeeffects. First, as capital flows in via the external surplus, localinterest rates begin to fall and local money demand begins to rise. Theincrease in money demand means that people are willing to hold largercash balances and hence the amount of sterilization needed is reduced.Second, as local interest rates fall, holders of domestic financialassets will seek to sell them and purchase foreign assets instead; thediversion into foreign assets also reduces the amount of sterilizationneeded to stabilize the domestic money market. The greater the degree ofsubstitutability between domestic and foreign assets, the faster suchdiversion will occur. Third, the external surplus induces a wealthtransfer from foreigners to domestic residents; this raises domesticdemand for foreign assets and lowers foreign demand for domestic assetsvia a "wealth affect" which is independent of changes in the prices oryields of home versus foreign assets.

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bank must accompany its intervention in the foreign e3 change market with aparallel intervention in the domestic money market.3

3.30 Thus, under exchange controls, active monetary policy can work as asubstitute for capital mobility to preserve money market equilibrium. Whythen do countries worry about the possibility that persistent current accountsurpluses may endanger monetary stability? An important reason is the abilityof the central bank to successfully intervene in the domestic money market.Whereas with full capital mobility the central bank is relieved of the burdenof monitoring the domestic money market and is left only with the task ofpegging the exchange rate, without capital mobility it must worry about bothtasks. One important indicator that it must monitor is the level of domesticinterest rates. By ruling out foreign borrowing and lending, exchangecontrols limit the degree to which private residents can diversify theirfinancial wealth. This often shows up in a level of domestic interest ratesthat is higher than the international level. When a current account surplusadds to domestic wealth, and domestic residents keep being prevented fromaccumulating foreign assets, the central bank may have to lower the price ofhome bonds (thereby raising interest rates) to convince residents to furtherincresse the share of their wealth invested in domestic assets.

3.31 This is already occurring in Korig7 At present, Korean interestrates are higher than international rates.- There are also indications ofupward pressure on interest rates in the bcnd market. As noted earlier, therate on the Monetary Stabilization Bond (MSBs), the principal open-marketliquidity control instrument, has been pushed up from 12.31 to 12.8Z in recentmonths; purchasers have been signalling in other ways also their concern thattheir portfolios are reaching saturation levels as far as such bonds areconcerned. The process of sterilization cannot be sustained indefinitelysince interest rates could rise to levels so high as to have significantlyadverse effects on domestic investment and output. It is argued in thissection that such an outcome can be avoided by partial liberalization ofcapital controls.

37/ The domestic market intervention, or sterilization, need not beequivalent to the forei6a market one if the current account surplusoccurs simultaneously with growth in nominal GDP since, in such a case,there will also occur some increase in domestic money demand which willautomatically absorb or sterilize a portion of the increase in moneysupply. The fact that Korean nominal GDP has been growing at roughly 16%in 1987 means that money supply can be permitted to grow by at least thisamount without engendering inflationary pressure. The income elasticityof money demand (for M2) in Korea is roughly unity.

<t ifor example, Government bond rates in Korea currently range between 12-15% while those in the US are presently around 9.5% (Treasury bonds) andthose in Japan around 5Z. The difference cannot be attributed toexchange rate expectations since the won is, if anything, expected toappreciate against the dollar and the yen.

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3.32 The experience of Germany over the last two decades or so providesan instructive and encouraging example of a successful sterilization program.Germany ran large current account surpluses in the mid-70s, and then againafter 1981. During the same period Germany was also subject to large capitalinflows: in the 1970s, as a result of portfolio diversification out of thedollar, in the aftermath of the collapse of Bretton Woods; later, as a resultof intra-European capital flows induced by anticipations of Deutsche Mark re-valuations inside the European Monetary System. Throughout this period, how-ever, the Bundesbank does not seem to have lost control of domestic monetaryaggregates.

3.33 The ability of the Bundesbank to sterilize is no surprise in view ofthe fact that Germany has a large domestic money market. There is howeveranother important difference between Germany and Korea: exchange controls.Korea imposes strict controls both on the purchase of foreign assets by resi-dents and on the acquisition of domestic assets by non-residents. Germany, onthe contrary, has no cont 50 s on capital exports, although it has often actedto limit capitsl imports. The possibility that lifting exchange controlsmay make the s_erilization task easier is an important issue in Korea. Theobvious argument is that when a country is accumulating claims on the rest ofthe world through a current account surplus, allowing domestic residents tohold foreign assets is a way to relieve the pressure on the central bank.This can be done by promoting the acquisition of foreign financial assets byallowing residents to make portfolio investments abroad as well as through theacquisition of foreign assets by domestic firms through joint ventures andfully-owned foreign subsidiaries. The German experience under regimes of par-tial and full capital mobility in the 1970s and 1980s respectively, suggeststhat increased capital mobility and increased substitutability between domes-tic and foreign assets helps sterilization by reducing the volume of openmarket operations necessary to sterilize any given external dist trance--acurrent account disturbance or an international portfolio shock. _

3.34 There is one major risk associated with lifting capital controls andpromoting the international role of the won. At the current value of the

39/ Since the late 1950s there have been no restrictions on German residentswho wish to purchase foreign assets. The German monetary authorities,however, have repeatedly resorted to administrative controls on capitalinflows. These measures were regularly introduced at times ofexpectations of a revaluation of the Deutsche mark, when the volume ofBundasbank's intervention in the foreign exchange market was endangeringthe stability of domestic monetary aggregates. Since 1981, however,capital inflows into Germany have been completely liberalized. Thus theGerman experience can be divided into two periods: a period of partialcapital mobility during the 1970s (featuring capital inflow controls) anda period of full capital mobility in the 1980s.

40/ A theoretical model showing why capital mobility facilitatessterilization and providing empirical verification in the case of Germanyis described in Giavazzi (1987).

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exchange rate and of domestic interest rates, the liberalization is likely tobe accompanied by large capital inflows into Korea: this would add to theaccumulation of foreign reserves and aggravate the sterilization problem,eventually making the current exchange rate stance untenable. However,exchange controls can be lifted one-way only--allowing Korean residents toinvest abroad but preventing non-residents from acquiring Korean assets. Asmentioned above, Germany responded to the exchange rate pressures of the early1970s with the imposition of strict controls on capital inflows. In morerecent years, one of the reasons why Germany has been able to keep itsdomestic monetary base in check, was the presence of exchange controls inFrance and Italy, its two major EMS partners. These controls have preventedFrench and Italian residents from responding to the anticipation of Deutschemark revaluations with large capital flows out of lire and French francs, andinto Deutsche marks. French and Italian controls on capital outflows havethus acted as substitutes for German controls on capital inflows. Theprincipal lesson of the German experience is that partial capital mobilityfeaturing controls on inflows but not on outflows makes it easier to manageliquidity generated by current account surpluses and, at the same time, makesit easier to maintain an exchange rate policy that promotes exports.

3.35 A program of liberalizing controls on capital outflows could beconducted in several steps. The first step would include easing of controlson the transfer of moderate sums of money associated with foreign travel andnon-commercial purchases. The second step would include relaxation ofapproval procedures for overseas direct investment. Firms with significantforeign earnings, and low foreign debt, might be permitted to undertakeproject investments of upto $1 million without needing to obtain clearancefrom the authorities. The third step might consist of allowing Korean banksto hold foreign financial assets in an amount of, say, upto 10% of their totalassets. Permitting banks to hold foreign assets would be a good way ofhelping them reduce the overall risk of their asset portfolios since thereturn on foreign financial assets has a low covariance with the return ondomestic assets (Anckonie and Chi, 1986). Such a step would bolster thefinancial position of Korea's banks as well as provide initiation into thesubtleties of international portfolio investment and management. Allowingbanks to spread their risks by holding foreign assets is especially desirablein a context of financial liberalization (Dooley and Mathieson, 1987).

Sterilization and the Fiscal Burden

3.36 Sterilization is presently being conducted through threeinstruments: MSBs issued by the BOK and Treasury and Foreign ExchangeStabilization Fund bonds issued by the MOF. The scale of the sterilizationeffort (see Table 1.8) raises concerns about the ability of the budget toabsorb the associated interest payment servicing burden without significantalteration of existing allocations.

3.37 MSB's are liabilities of the Bank of Korea. A technical problem hasarisen in that the BOK does not possess a sufficient stock of such securitiesto satisfy the requirements of the sterilization operations planned for 1987,let alone over a longer period. A related problem is that the BOK does notpossess sufficient reserves (or accumulated profits) to finance the debt

s

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servicing associated with its past issue of MSB's, let alone anticipatedfuture issues. Interest paid on MSBs in 1987 alone come to 900 billion won or53% of total BOK operating expenses (see Table 3.5), up from 252 billion wonin 1986. From a macroeconomic point of view, of course, the fact that it isthe BOK that carries the burden is irrelevant. A rapid rate of sterilizationcreates a burden which is analytically best considered a public debtconcern: it does not really matter whether the BOK or some other agency ofthe goX17nment (such as the MOF) carries the associated deficit on itsbooks.-

3.38 As a public debt concern the interest rate burden is, at present,manageable but shows signs of becoming more difficult. Interest payments byGovernment on liquidity control bonds are rising at a much higher rate thaneither Government revenues or expenditures. The ratio of such payments tooverall interest payments has risen from 3% in 1986 to 22% in 1987; the ratioof overall interest payments to overall budget expenditures has risen from 7%to 8% during 1986-87, but if the payments made by the BOK are included, thechange is much more drastic, from 11% to 14% (see Table 3.5). If this patternof increase is maintained over the next few years it is quite possible thatcertain existing allocations will have to be drastically reduced as aproportion of expenditures. It should be emphasized at this juncture that theconcern here is not with the ability of the budget to absorb such interestpayments in an absolute sense but only with the possible disruption ofexisting fiscal priorities. Indeed as long as the growth of GNP exceeds theinterest rate on the public debt and the ratio of government revenues to GNPremains constant, there should be no problem in absorbing such interestpayments in a non-inflationary manner.

41/ Some governments prefer that central banks rather than treasuries conductsterilization operations for two reasons. The first is that thefinancial operations of central banks are an off-budget matter whilethose of ministries are budgetary matters, subject to an often lengthyparliamentary approval process. Thus an autonomous central bankpossesses the flexibility necessary to conduct sterilization operationswhich other, budget-dependent, agencies do not. A second reason is thatthe cause of fiscal conservatism is best served by keeping sterilizationoperations out of the parliamentary and budgecary process. It is feltthat were parliament to exercise greater control over money creation andsterilization matters, fiscal irresponsibility would result sinceparliamentarians could then no longer be thwarted in their pet spendingplans by the argument that money was not available--they would vote to"create" the needed money. Monetary policy would then be driven byfiscal policy and could lose its stabilization role as an occasionalcounterweight.

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Table 3.5: INTEREST BURDEN OF STERILIZATION(billion won)

1985 1986 1987(projected)

A. Interest Payments by BOK: f) 583 770 1,062A.1. on Monetary Stabilization Accounts 375 517 329A.2. on Monetary Stabilization Bonds 208 252 736

B. Interest Payments by Government: 1,093 1,358 1,900B.1. on Treasury Bills 0 30 109B.2. on Foreign Exchange Stabilisation Bonds 0 0 200B.3. on Other Securities /a 1,093 1,328 1,591

C. Operating Expenses of BOK 948 1,096 1,414

D. Reserves of BOK 372 190 132

E. Government Budget Expenditures 16,751 19,260 21,185

F. Percentages

A/C 61 70 75A/D 157 406 805B/E 7 7 9AIB/E 10 11 14

/a "Other securities" consist of special purpose bonds such as HousingBonds, Grain Bonds, etc.

Source: Monthly Statistical Bulletin, Bank of Korea; Staff estimates.

3.39 The point that an open market operation carried out to sterilize aninflow of reserves may give rise to an unsustainable interest burden may beclarified by considering the case of debt issued to finance government expend-iture. There are two reasons why the government issues debt: to financecurrent expenditure, to finance public investment. In order to satisfy theauthorities' intertemporal budget constraint, an increase in debt issued tofinance current expenditure will have to be paid for through an increase intaxes sometime in the future: the reason is that current expenditures (wagesand salaries of public employees, for example) yields no return and thereforedoes not produce a revenue to be used to service the debt. Debt-financedpublic investment projects, on the contrary, may pay for themselves, and thusmay not require a future tax increase. The obvious condition is that the realreturn on the public project be at least as high as the real interest rate onthe debt.

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3.40 A central bank liability issued to sterilize an inflow of reservesis very similar to debt issued to finance public investment. A sterilizedintervention in the foreign exchange market is equivalent to a central bankpurchase of a foreign security paid for with the issue of a domesticsecurity. If the real interest rate paid on the security issued by thecentral bank is equal to the real interest rate received on the foreign assetpurchased by the central bank, there is clearly no problem of debt-servicebecause the net worth of the authorities has not changed. Problems may arise,however, if the two real rates of return are not equal--as seems t- he thecase today in Korea. If the authorities promise to pay, on the assats theyissue, a return that exceeds the return they can receive from the foreignassets in which they invest, they will not be able to satisfy the inter-temporal budget constraint without changing the path of taxes. An importantreason why the two returns may differ is that the authorities may issueliabilities that are not very "attractive" to the private sector. If forexample the authorities sterilize by issuing short-term instruments only, theywill soon saturate private portfolios: new issues of sterilization bonds willrequire a premium. Thus a prudent strategy would be to issue a diversifiedmenu of assets.

3.41 In the presence of exchange controls, however, all domestic-currency-denominated assets (independently of their maturity) may require apremium because the private sector would like to diversify into foreign-currency-denominated assets. A solution would be for the central bank to runits sterilization operations issuing foreign-currency-denominated bonds. If,because of exchange controls, these are the only foreign-currency-denominatedbonds that the private sector can hold, they will sell at a higher price thanthe price at which the central bank can purchase foreign assets in theinternational financial market. Rather than giving rise to an interestburden, this is a case when sterilization yields a net revenue to the centralbank. The reason of course is that the central bank reaps the monopolyprofits associated with being the only agent in the economy that has access tothe international financial market.

3.42 A final comment is that lifting exchange controls would reduce thepossibility that the issue of stabilization bonds may give rise to an interestburden. With perfect capital mobility, the domestic interest rate tends tomove close to the international rate: this reduces the spread between thereturn on central bank reserves and the cost of servicing the stabilizationbonds.

3.43 The Privatization Initiative. Also relevant from the fiscal pointof view is the privatization initiative announced in early 1987. There areplans to divest about $1.25 billion worth of Government-owned equity in avariety of enterprises over the period 1988-90. This measure could be usefulfor monetary restraint in two ways: it would reduce private sector moneybalances by $1.25 billion directly and it could, if transferred to the BOK orthe FESF, help to service the debt associated with sterilization operations ina non-inflationary manner.

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D. Debt Repayment and Sterilization

3.44 Given a sterilization target one can devise technically efficientways to achieve it and policy measures to assist in the process. Thepossibility remains, however, that those measures may not be enough to avoidsignificant macroeconomic disruption. In this case it is worth consideringmeasures to reduce the sterilization target directly. This can be done byusing a given external surplus to repay outstanding foreign debt and/or byreducing the size of the external surplus itself by a variety of trade andexchange rate measures. The latter measures are considered in Chapter 5 and6; this section discusses the connection between debt repayment andsterilization.

3.45 An obvious way to use the foreign exchange generated by the currentaccount surplus is to repay foreign debt. The simple case is when foreigndebt is a liability of exporters. In this case exporters may use the proceeds-f their foreign sales to repay their debt, thus effectively avoiding anyinflow of foreign exchange. Sterilization is automatic. If foreignindebtedness is not concentrated among exporters, the technique is a littlemore complicated, but the result is the same. In this case tne exporting firmreceives a dollar as payment for its sales abroad. The central bank inter-venes purchasing the dollar and creating won, thus raising the stock of high-powered money. To sterilize the increase in the money stock, the central bankcan sell the dollar to a firm that holds foreign debt: this transactionreduces the money stock by one dollar, and thus effectively sterilizes theincrease associated with the initial intervention in the foreign exchangemarket. Finally, the firm involved in the second transaction uses the dollarpurchased from the central bank to repay part of its debt.

3.46 A more complicated situation arises when the debt is not held by theprivate sector, but directly by the central bank--or by any other governmentagency that we may aggregate into the public sector. Two cases may be distin-guished. One case occurs when the central bank has borrowed abroad one dollarto lend it to the private sector (for example to firms who need foreignexchange to buy imported materials). In this case the authorities simply actas an intermediary: when the private sector runs a current account surplus,the central bank asks for its loan to the private sector to be repaid. Theprivate sector repays the loan depositing the dollar earned from its netexports with the central bank, that in turn uses it to repay its debt. Thestock of money not affected. A different case arises when the bank borrows adollar abroad and then lends wons to the private sector. In this case whenthe private sector runs a current account surplus, the central bank intervenesin the foreign exchange market buying up dollars (that it uses to repay itsown debt) and "paying" for them by extinguishing the debt that firms have vis-a-vis the central bank. Once again the stock of money is unaffected.

3.47 Korea has reduced its outstanding external debt by almost $10billion since 1985 by prepaying some loans and by abstaining from externalrefinancing of others that fell due. It intends to continue using projectedcurrent account surpluses to reduce its external debt by about $2 billion perannum over the next five years. It has even encouraged the private sector to

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prepay some external loans and be refinanced through the Bank of Korea atterms which are considerably more attractive than those currently attaching tonew domestic loans. Finally, it has put a freeze on most public sectorforeign borrowing and tightened the guidelines to be applied to private sectorforeign btrrowing.

3.48 Debt repayment as a monetary control strategy appears justified inthe short run given the suddenness and the scale of the liquidity surplus andgiven the inflationary risk of attempting to increase the rate of growth ofGNP beyond its current level of 12.5%. Indeed, under present conditions, itcould be said that debt repayment is playing as important a role in monetarycontrol as is sterilization. In the long run perspective, however, debtrepayment would require a different justification, based on the costs andreturns to investment in Korea versus investment abroad. If it is perceivedthat the sterilization burden of prospective external surpluses will continueto be unsustainable without assistance from debt repayment, the desirabilityof relieving monetary pressures directly by reducing external surpluses shouldbe considered.

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IV. TRADE IMBALANCES: ECONOMIC CAUSES, POLITICAL CONSEQUENCES

The Overall Current Account Surplus

i~~~~~~~~~~~~~~~~4.1 Korea s external accounts have improved dramatically in the last twoyears; indeed, recent results suggest a fundamental turning point in Korea'sposition in the world economy. Export gains have been extremely impressive,not only in terms of overall market share, but also in quality and diversity.The annual improvement in Korea's trade balance increased from an already-impressive $0.5-1 billion in the early 1980s to approximately $4 billion peryear in 1986 and 1987. With these gains, the $4.8 billion deficit of 1980 hasbeen transformed into a likely $10 billion surplus in 1987.

4.2 The surplus is presently running at about 8Z of CDP, or approxi-mately twice the target announced by Covernment early in 1987. Someeconomists here argued that the surplus is inconsistent with Korea's highreturn on investment and is unsustainably large. At the same time, othersargue that Korea's present trade position is still subject to risk, and thatdebt retirement in any case is an important immediate objective. The won hasin fact appreciated against the dollar in 1987 but, due to the strengtheningof the yen, its effective exchange rate has remained unchanged.

4.3 This Report does not take a position on the controversial issue ofthe optimal size of the external surplus, as this determination is affected bymany non-economic considerations. Korea's debt is still large relative toGDP, and while Kcrea is eminently creditworthy, debt repayment is a matter ofpolitical as well as economic objectives. However. in light of the fact thatthe surplus now exceeds Government targets, the RLport does analyze alterna-tive ways to stimulate imports and reduce exports.

The Problem of Bilateral Imbalances

4.4 The main focus of the present analysis is an extremely troubling'side-effect of Korea's improved competitiveness: the need to control andmanage trade conflict. Between 1981 and 1986 bilateral trade with the USmoved from a $0.4 billion deficit to a $4.2 billion surplus. In the contextof the large and intractable overall US deficit, Korea's trade surplus facesgrowing criticism, and is increasingly attributed to alleged "unfair"practices that promote exports and restrict imports. Forthcoming US tradelegislation may soon provide instruments for translating criticism intoprotection. In the meantime, several highly visible safeguard actions havebeen taken against Korean exports, and Korea has been the subject of severalrounds of Congressional hearings.

4.5 The recent strengthening of Korea's current account position and thelarge real effective depreciation of the won during 1985-86 have promptedvarious governments and economists t) argue that the won needs to be revalued(see Balassa and Williamson, 1987). Some won appreciation has occured since1986, but Korea's current surplus has continued to grow. The large surplus isbeginning to strain domestic macroeconomic policies, as earlier chapters haveshown, and problems are rapidly emerging in the areas of monetary managementand price stability.

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4.6 If present macroeconomic directions remain unchanged, and Koreacontinues to run large e-;ernal surpluses then domestic and externalpressures are likely to intensify. But even with macroeconomic adjustments,the trade problems with the US will remain difficult. It is therefore notsurprising that the reduction of the bilateral trade surplus has risen to aprominent place on the Korean policy agenda. Announced Government policyis: (a) to hold down the size of the trade surplus with the United States,and the trade deficit with Japan, respectively, at the 1986 level; and (b) toincrease imports through the expansion of investment and the accelerttion ofimport liberalization, rather than drastically appreciate the won.-

4.7 To implement these objectives, measures have been already adopted tolimit exports to and increase imports from the US, to switch imports fromJapan to the US, and to localize the production of machinery and componentsnow predominantly imported from Japan. For better or worse, the management ofthe two bilateral trade imbalances is becoming important and complex, andalready encompasses a comprehensive portfolio of programs, incentives, andinterventions in various detailed, produ^-t-specific decisions. This clearlyhas implications for Korean indust^al policy which has recently undergone amajor transition in its own right.-

4.8 The issues of trade management will not recede or be resolvedeasily. The purpose of this and the next chapter is to analyze the seriouschallenges that these issues raise for Korean policy. This chapter examinesthe economic causes of the trade imbalances for insights on how they might bemanaged. Building on these findings, the next chapter evaluates currentpolicy and develops recommendations for the future. Inevitably, themanagement of trade surpluses requires different policies from those used inthe past to manage escalating deficits and indebtedness. Korea's new economicrealities and policy objectives call for a careful reexamination of theprinciples of Korean trade policy and of the role of Government in theeconomy.

Recent Developments in Korean Trade

4.9 Korea's trade balance turned decisively positive in the second halfof 1985, reflecting a sharp increase in exports without a correspondingincrease in imports. Export growth since has continued to outpace importgrowth. Subsequently, the surplus received a further boost from the collapsein oil prices in the second half of 1986. As Table 4.1 shows, the overalltrade surplus in 1987 may well be double that of 1986.

42/ These objectives were announced in April 1987 in the context of a majorstatement on future economic policies and programs.

43/ See Korea: Managing the Industrial Transition, World Bank (1987).

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Table 4.1: RECENT TRADE RESULTS(millions of US lollars)

Category 1984 1985 1986 1987(projected)

Overall TradeEsports 29,245 30,283 34,716 44,000Imports 30,631 31,136 31,584 37,000Yet Exports -1,386 -853 3,132 7,000

Trade with USExports 10,528 10,789 13,880 18,000Imports 6,877 6,554 6,545 8,000Net Exports 3,651 4,235 7,335 10,000t

Trade with JapanExports 4,610 4,546 5,426 7,000Imports 7,640 7,557 10,869 12,000Net Exports -3,030 -3,011 -5,443 -5,000

Source: International Financial Statistics and Korean Traders Association.

4.10 These developments are partly due to two favorable external events.The first was the worldwide decline in oil prices. Korean crude oil importsdeclined from $4.9 billion to $2.9 billion between 1985 and 1986, with gainsi.n processed petroleum products contributing a further $0.4 million of sav-ings. The second key factor was the appreciation of the yen. The yen beganto gain on the won already in 1984, but its rate of appreciation acceleratedin 1985 when the yen substantially strengthened against the dollar while thewon continued to fall. The won's real effective exchange rate has declinedsubstantially (see Figure 4.1), whether one uses weights associated with im-ports, exports, or export competition. Since 1980 the real depreciation isapproximately 25 percent overall, and 36 percent against Japan.

4.11 In the context of Korea's open economy, depreciation has had complexconsequences. Overall, Korean competitiveness improved, but some key importsfrom Japan became significantly more expensive. Further, due to the highimport content of Korean exports and investment (more on this below in theinput-output analysis of the demand for imports), depreciation has had verylimited effect on the volume of imports. Overall, Ro (1987) has estimatedthat depreciation in 1986 increased exports by $4.4 billion, and alsoincreased imports by $2.3 billion, for a net trade effect of only $2.1 bil-lion. (The depreciation of 1986 represents about half of the depreciationsince 1980.)

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FIGURE 4.1ALTERNATIVE REAL EXCHANGE RATE INDEXES

1.2 _

1.10^&

0.9

I *.

07

1980 81 82 83 84 85.1 85.3 86.1 86.3 87.1

FIGURE 4.2KOREAN EXPORTS BY PARTNER

(%)

100

90 .

80

70 - 4-<" + t,"'0 '

60 U, Un t S+4bs

50 v

40

30.. oDvIe '-u.S

20

10 _a-a zo

100 I U I I I I I I ~I T I

1965 1970' 1975' 1980 1985

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4.12 But quite apart from depreciation and oil price declines, Korea'sexport performance shows impressive signs of progress. Recent export gainsare widely-based and reflect profound changes in the dynamics of Korean com-parative advantage. Leading market positions are now being established in arange of sophisticated consumer goods that were previously exported primarilyby Japan. Some of the most dynamic exports are shown in Table 4.2. This listis strikingly diverse; it includes labor intensive commodities such asapparel, footwear, and toys; basic intermediate products such as iron andsteel; and advanced industrial and consumer goods such as machinery, automo-biles, and electronic products. It also demonstrates dramatic gains in newproducts. More than 6 percent of early 1987 exports were in two key products--automobiles and VCRs--that were not exported in significant amounts only twoyears earlier.

4.13 It is also important that impressive gains are now being registeredin Japanese markets. Between 1980 and 1985, the increase in exports to Japanwas only 23 percent as large as the increase of exports to the United States.In the first half of 1987, however, the increase in exports to Japan wUs 63percent that of the increase to the United States. As the level of exports toJapan increases relative to that to the United States, and even larger shareof Korea's export growth is likely to occur in the Japanese market. In thismarket, gains are particularly large in textiles, apparel, and footwear, sinceJapanese imports are not subject to formal quotas. But rates of growth (ifnot yet absolute volumes of exports) are high also in various types ofmachinery and electronic products. These developments portend an importantand timely adjustment in the Korean export bundle, since the growth cf /imports is now likely to diminish relative to that of Japanese imports.

4.14 In sum, rapid progress in both the product and geographicaldiversity of Korean exports provides a strong base for continued export growthin the future. The majo= external factors responsible for recent progress donot appear to be tempor-ey, and are supported by fundamental improvements.Thus, recent developments should, in retrospect, mark the beginning of an eraof strength in Korea's external accounts. Adverse political or economicdevelopments could always derail these trends, but barring unexpected crises,prospects are now very favorable.

Bilateral Trade Patterns

4.15 Since bilateral trade frictions are at the heart of recent policyconcerns, it is useful to examine briefly the history of Korean bilateraltrade. The United States and Japan have been Korea's main trading partnerssince World War II, accounting for as much as 10 percent of Korean exports anda similar percentage of Korean imports (see Figure 4.2). Gradually, otherdeveloped and developing partners became more important in the 1970s; ties

44/ The overall deficit with Japan has begun to shrink recently, the deficitin August and September 1987 being lower than that in these months in1986. If the recent trends continue, there is a good chance that the1987 deficit with Japan will be kept at the 1986 level of $5.4 billion.

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Table 4.2: AREAS OF RAPID EXPORT GROWTHlUST million and percentages)

To all countries To the United States To JapanYear-to-year Year-to-year Year-to-year

1986 increase 1986 increase 1986 increaseProducts value 1986 1987.Q1 value 1986 1987.Q1 value 1986 1987.Q1

Total

Chemicals and RubberRubber products 353 45.6 9.2 64 59.4 4.7 106 49.2 -9.7Synthetic fibers 585 20.1 49.7 191 -6.0 51.9 19 76.3 80.9Other chemicals 946 27.7 37.4 324 45.9 58.8 176 46.4 4.4

Metals and ProductsIron and steel 2,489 -3.6 -5.3 678 -18.1 -10.4 546 19.3 13.0Foundry products 284 38.1 40.9 138 31.6 16.9 36 67.4 120.3Containers 258 -7.8 86.9 157 -6.4 67.1 31 -38.7 142.9Other metal products 623 15.8 34.8 297 23.1 20.1 30 94.3 358.0

MachineryPrecision Instruments 423 24.3 56.9 211 43.4 116.0 30 -27.9 221.6Domestic appliances 568 92.5 79.7 359 65.1 48.9 6 109.8 605.7Heavy elec. machinery 106 13.1 36.6 21 54.5 46.6 11 9.7 69.8Industrial electronics 1,211 61.5 53.5 793 47.4 47.8 20 40.3 254.8Consumer electronics 2,442 58.8 93.3 1,249 40.0 57.1 60 122.1 118.7Color TV 534 42.3 91.1 258 44.1 24.0 1 -59.0 1,896.0VCR 551 166.7 141.3 335 - 88.9 1 - 12.7

Electronic components 2,987 49.5 49.1 1,341 46.2 15.7 525 33.3 65.6

Transport EquipmentAutomobiles 1,403 151.9 162.4 1,001 1,470.3 124.6 2 85.3 363.9Auto parts 173 18.7 129.7 108 45.9 223.4 17 131.3 212.4

Textiles and ApparelApparel (woven) 2,388 11.7 26.8 1,123 4.0 8.4 337 50.6 103.5Jackets 456 25.9 48.5 161 -1.3 17.6 94 74.4 178.0Men's clothing 99 1.8 27.5 72 6.4 22.1 6 86.1 540.4Shirts 895 6.4 29.3 401 -4.4 0.4 134 23.2 84.2

Apparel (knitted) 1,856 36.6 31.5 908 26.0 12.1 479 70.2 45.5Sweaters 1,132 35.2 40.3 610 21.3 6.7 272 71.8 174.9

Leather apparel 588 41.3 108.9 253 19.9 75.8 33 50.9 222.5Furs 189 12.9 37.3 118 -4.3 25.7 25 87.6 158.5

Other ProductsFootwear 2,109 34.2 22.7 1,501 30.3 2.7 152 622.5 101.7Musical instruments 129 69.8 93.7 70 52.9 87.2 5 165.9 136.1Handicrafts 146 12.9 46.9 70 37.6 41.5 29 -16.3 16.2Toys and dolls 728 51.2 76.9 540 49.5 67.6 36 165.8 231.5

Source: Japan External Trade Organization, using Korean Trade Association data.

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with the Middle East strengthened, and shipbuilding and overseas constructionemerged as key export industries. By the late 1970s, trade with the US andJapan had declined to approximately 50 percent of total Korean trade.

4.16 In the early 1980s, however, United States markets assumed renewedprominence with the sharp appreciation of the dollar. Table 4.3 shows thatbetween 1982 and 1986 the United States alone accounted for 54 percent ofKorea's spectacular export growth. At the same time, the role of Middle Eastand other developing countries diminished. On the import side, a similarlyskewed pattern emerged, with Japan accounting for no less than 78 percent ofthe increase in Korean imports. These trends help to explain the roots of thepresent trade conflict and of Korea's new initiatives at decreasing both thesurplus with the United States and the deficit with Japan.

Table 4.3: EXPORTS BY MAJOR PARTNER(billions of US dollars)

PercentPercent share in

Country 1982 1986 share increase

Total 21.6 35.3 100 100

United States 6.3 13.7 38.8 54.0Japan 3.4 5.4 15.3 14.6Other Developed 4.4 7.2 20.4 20.4Three Asian NICs 2.3 3.2 9.1 6.6Middle East 2.1 1.9 5.4 -1.5Other Developing 3.1 3.9 11.0 5.8

Source: International Financial Statistics.

Note: The three Asian NICs include Hong Kong, Singapore and Taiwan (China).

4.17 American observers increasingly argue that Korea's success in USmarkets and the failure of US exports in Korean markets is evidence ofasymmetric market access--that is, more favorable treatment of Korean goods inUS markets than US goods enjoy in Korean markets. These arguments, typicallybased on business anecdotes, are difficult to disprove with statistical dataalone. Nevertheless, a rough statistical index-the so-called "gravitycoefficient"--can provide insights about the relative shares that countrieshold in each others' markets. The gravity coefficient compares the marketshare that a country achieves, say in the Japanese market, with its marketshare worldwide. Analyses of such coefficients can then help to judge howwell a country's products are received, say, in Japan as compared to othermarkets.

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4.18 Ideally, gravity coefficients should be calculated for disaggregatedcommodity categories to avoid distortions due to the differing product mixes(comparative advantages) of the trading economies. Product compositioneffects aside, a gravity coefficient of 1.0 would indicate average access,that is, the same average market share (corrected for differences in theproduct composition of imports) in, say, Japan, as in ocher markets. A valueabove one suggest larger than average market shares, or atypically favorableaccess.

4.19 Gravity coefficients based on disaggregated Korean trade data showthat linkages with both Japan and the US are of above-average intensity--thatis, gravity coefficients calculated for Korea's exports to these countries aswell as for their exports to Korea exceed unity (see Figure 4.3). Theintensity of linkages with the US, and to a lesser extent with Japan, is notvery different whether calculated from imports or exports--there is no strongevidence of asymmetric access. Gravity coefficients are somewhat higherbetween Korea and Japan than between Korea and the US, and are considerablylower for Korea's other trade partners.

4.20 The explanation for the large observed trade imbalances, therefore,does not lie in differences in access vis-a-vis other trade partners on thelevel of individual products. Rather, the imbalances are attributable todifrerences in trade composition, that is, in comparative advantage. Thehypothesis explored below is that there is an inherently better "fit" betweenKorean export patterns and US import patterns, and between Korean importpatterns and Japanese export patterns, than vice versa.

Comparative Advantage and Bilateral Trade

4.21 The composition of Korea's commodity exports has changedsubstantially in recent years and is increasingly dominated by engineeringproducts--machinery, electrical machinery, transport equipment--at the expenseof both basic intermediate goods and light manufactures (see Figure 4.4). Therecent acceleration of this trend has been already highlighted in Table 4.2,which shows extremely rapid growth in a wide range of technologically advancedproducts. These trends are also associated with major geographical changes.In particular, the trend toward more sophisticated manufactures has beenaccompanied by a shift in exports to the United States, while growfingrequirements for component and capital goods imports has shifted importsfurther toward Japan.

4.22 Import trends also show an increase in engineering products at theexpense of other categories. This is partly the result of declining oilprices, but it also reflects the growing importance of investment in Koreanexpenditure and increasing intra-industry trade in electronics and machinerybetween Korea and Japan and other East Asian countries. Since Japan is adominant supplier of advanced engineering components and capital goods, thegeographical effect of these trends is to increase the fit between Koreanimports and Japanese exports.

4.23 The changing geographical bias of Korean trade emerges clearly incorrelations of the product composition of Korean exports and imports with the

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FIGUiJR 4.3TRADE INTENSITY 'NDEX BY PARTNER

3 43:2

3

~2.6

2.2

001.8

`1.2

0.2

Jap U Saud India HKong Sing 'Norw Cana Fran Germ UK

- rKorean Imports Korean Exports

FIGURE 4 .4KOREAN EXPORTS BY TYPE

100- -

90 fI80

Trodure' r,wid l

70

60

50

40

30 -> L4i Mach

2

1

mm965- -19-0 m97 mi965 1970 1975 1q8 ' ~3i 185

- 82 -

imports and exports of the US, Japan, and other developed countries (seeTable 4.4). The fit between Korean export composition and US importcomposition is reasonably high (the correlation coefficient 0.38), but it ispoor between Korean exports and Japanese imports (-0.39). Similarly, Koreanimports and Japanese exports are much more highly correlated (0.34) thanKorean imports and US exports (0.13).

Table 4.4: CORRELATIONS OF REvEALED COMPARATIVE ADVANTAGE(RCA) INDEXES

Korean Koreanexport RCA import RCA

Export RCAsUS -0.32 /a 0.13Japan 0.52 7a 0.34 /aOther Developed -0.11 0.18

Import RCAsuS -0.38 /a -0.44 /aJapan -0.39 7a 0.13Other Developed 0.00 0.36 /a

/a Significant at 90% level.

4.24 There is also a strong and interesting correlation between Koreanexports and Japanese exports (0.52). Detailed analysis in Petri (1988) showsthat these similarities are even more striking when Korean exports are relatedto Japanese exports of approximately fifteen years ago, and in general, exceedthose found between Japan and other countries in East Asia. These deepparallels between Korean and Japanese export structure are due to a variety offorces, including similarities in endowments, close economic ties, andexplicit efforts by Korean business and Government to learn from Japaneseexperience.

4.25 Parallels between Korean and Japanese export patterns significantlyreinforce Korea's dependence on imports from Japan. With long experience inthe products that Korea is now emphasizing, Japan has a clear lead over othercountries in the supply of the relevant capital goods and components. Koreanfirms have also tended to rely disproportionately on Japanese technology,machinery, and in some cases, joint investment. These vital business linkageswith Japan have probably increased bilateral trade relations even beyond thelevels that would be expected given the general statistical fit between Koreanrequirements and Japanese comparative advantages.

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Investment and Bilateral Trade

4.26 Recent investment trends suggest that the linkages between Korea andJapan are continuing to expand. Japanese investment in Korea has beenhistorically higher than US investment, and the divergence has increasedrecently with the growth of Japanese capital outflows and the decline of UScapital outflows. In early 1987, Japanese investment was running at approx-imately twice the rate of US investment (see Table 4.5). Investment linkagesare expanding particularly rapidly in manufacturing, and specifically in theelectronics subsector. Many of these investments are being made by Japanesefirms and are likely to result in closer Korean-Japanese linkages.

4.27 Some Korean observers are concerned that Japanese investment inKorea may be designed to circumvent US and other trade restrictions againstJapan. Such investments could adversely affect Korea's access to foreign mar-kets and thus be detrimental to the development of Korean industry. Paradoxi-cally, the main concern in Japan is that investments in Korea and other devel-oping countries will have a "boomerang effect" on exports back into Japan.

Table 4.5: DIRECT FOREIGN INVESTMENT IN KOREA(millions of US dollars)

Z overAverage Jan-May same period1980-84 1985 1986 1987 in 1986

By CountryJapan 136.3 364.3 137.7 150.6 232uS 97.8 108.0 125.1 87.5 148Hong Kong 14.3 13.4 12.8 41.9 n.a.Sweden 8.2 7.0 31.5 24.8 n.a.UK 3.5 12.0 15.4 42.9 n.a.Others 24.7 27.3 31.2 24.4 n.a.

By SectorAgriculture 2.4 3.4 0.1 2.7 n.a.Mining 0.7 1.0 1.3 0.0 n.a.Manufacturing 149.3 180.9 269.3 289.3 n.a.Chemicals 28.7 39.2 30.8 46.1 609Metals 4.8 1.2 7.6 7.4 296Machinery 4.9 7.2 29.8 17.7 -16Electronics 42.0 55.5 66.6 100.1 694Transport Eq. 35.8 44.8 61.1 43.9 n.a.

Hotels 103.8 308.3 61.6 74.4 144Services 30.1 38.4 21.5 5.6 n.a

i TOTAL 284.8 532.0 353.7 372.1 244

Souirce: Ministry of Finance.

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4.28 There is no quantitative information available on the marketstargeted by new foreign investment, and in any case the dramatic currencyrealignments that started in 1985 are still too recent to be reflectedsignificantly in current investment data. The policy implications arenonethless important. Korea should welcome investments aimed for the Japanesemarket, since penetration of the difficult Japanese distribution system ispresumably easier for Japanese firms. In principle, investments for theKorean and other markets are also desirable, but trade diplomacy problems maylimit the attractiveness of investments designed to serve US markets. If suchinvestments curtail (or threaten to curtail) other Korean exports, a carefulcost-benefit analysis is needed to determine whether the gain of foreignmarketing experience, capital, aid technology are sufficient to offset lossesto other branches of the economy. In this context, continued screening ofinward investment appears to be justified.

Bilateral Imbalances and Political Pressure

4.29 However justified bilateral imbalances may be from an analyticalviewpoint, they have given rise to increasing political pressures in partnercountries. The most serious opposition has emerged in the United States,where a new trade law threatens to provide a range of instruments for imple-menting protection. But protectionist pressures are also rising in Canada,where the successful Hyundai automobile was the subject of an anti-dumpinginvestigation, which ultimately exonerated the Korean exporter.

4.30 Even without the recent increase in bilateral imbalances, tradediplomacy would have been important for Korea because its export bundle isconcentrated in products-light manufactures and basic intermediate goods-that are unusually protection prone. Table 4.6 reproduces UNCTAD data ontariff levels and non-tariff barriers facing different types of manufacturedimports in developed countries. A casual look at this table indicates thatKorea's principal exports face above-average barriers abroad. Specifically,if Korean export weights are used to calculate an average level of protectionfaced by Korea's manufactured exports, the resulting averages (6.6 percenttariffs, 35.2 percent non-tariff barrier coverage) are higher than those forany other country group (see Table 4.7 and Petri, 1988).

Table 4.6: NTBs AND TARIFFS APPLIED TOIMPORTS IN DEVELOPED COUNTRIES

NTB coverageProduct (X value) Tariff rate

Iron and steel 64.2 3.4Non-Ferrous metals 6.4 1.3Chemicals 12.7 3.1Leather 13.9 3.1Textiles 39.6 7.9Clothing 67.4 11.9Footwear 32.5 9.0Other manufactures 15.8 3.9

Source: UNCTAD (1987).

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Table 4.7S AVERAGE PROTECTION FACED INDEVELOPED COUNTRY KARKIET

Exporting NTB coverageregion (Z value) Tariff rate

Korea 35.2 6.6United States 16.1 3.8Japan 18.2 3.9Other Developed 20.3 4.1East Asian NICs 29.2 6.1East Asian LDCs 26.3 5.3Other Developing 27.0 501

World 20.9 4.3

Note: Export-weighted average of NTB and Tariff indexes fromTable 4.6.

4.31 Korea also ranks high in the area of "contingent" protection, thatis, in the number of cases of anti-dumping, subsidy, and safeguard caseslaunched against it in the United States. Over the 1980-1986 period Koreafaced the 3rd highest number of anti-dumping and subsidy cases k34, onlybehind Brazil with 49 and France with 38, and even with Japan). But thenumber of investigations has not risen in recent years. The largest number ofcases (18) occured in 1982 in the steel industry prior to the adoption ofvoluntary export controls; since then the number of cases has been steady at5-8 per year.

4.32 The key threat facing Korea today is not product-specificAdiministered protection, but the possibility of broad discriminatory actionunder a new US trade law. A new trade act is presently being considered withprovisions that require mandatory retaliation against countries with bilateraltrade surpluses such as Korea's. The final form of this act is still notdetermined, and its eventual protective effect will, in any case, depend onhow it is implemented. It is nevertheless clear that the new trade bill willprovide broader instruments for protection than have been available in thepast.

4.33 It is especially worrisome that US policy makers frequently groupKorea with Japan and Taiwan (China) as targets of trade action. This groupingis unfair because Korea is an open economy, a relative new-comer in the tradesurplus league (there was no structural trade surplus until two years ago),and has recently pursued market opening more energetically than either Japanor Taiwan (China). Nevertheless, Korea's bilateral surplus with the US islarger, in relative terms, than Japan's, and Korea's outward-oriented strategyis frequently compared to Japanese interventions in earlier stages of

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development. There are major differences between Korea's economic structureand policies and Japan's, and it is clearly important to emphasize thesedifferences at every opportunity, but realistically Korean efforts at tradediplomacy will continue to be difficult as long as the trade friction betweenthe United States and Japan remains intense.

Import Dependence and Economic Structure

4.34 Notwithstanding the political problems caused by Korea's bilateraltrade, the present imbalances are difficult to change because they are closelytied to the structure of Korean comparative advantage. With exportsaccounting for approximately 40 percent of GNP, the Korean economy is open anddependent on trade. lt is also quite specialized, in the sense that manyproducts tend to be either imported or domestically produced. In many casesthe pattern of specialization is also highly partner-specific--for example,imported tape heads for VCRs are manufactured only in Japan. Extensivespecialization is significant for trade policy, for it limits the possibili-ties for switching and/or controlling imports.

4.35 Import dependence, in general, is rot a liability, but ratherevidence of efficient specialization. Indeed, the specialized trade structuredescribed below is partly the result of Korea's innovative duty drawbacksystem, which exposed Korean exporters to world relative pt,es and encouragedthem to find profitable "niches" of comparative advautage.- It is also theresult of the rapid growth of technologically advanced industries, which atfirst require significant quantities of imported inputs and capital goods.Contrary to views frequently voiced in Korea, there is nothing inherentlyinefficient about an industry that is highly dependent on foreign suppliersand markets--i.e. has low domestic value added relative to output. If anindustry is internationally competitive, it will contribute to nationaleconomic welfare regardless of whether its stage in a particular productionprocess is small or large. But it is more difficult and dangerous tointervene in the pricing structure of a finely specialized economy, becauseits competitiveness depends critically on access to imports at world marketprices.

4.36 Specialization and trade dependence can be examined withconsiderable precision using input-output data. The 396 sectors of the Koreaninput- output table provide ample detail, for example, for distinguishingdomestic, exporting, or import-substituting activities, and for examiningdifferences in import dependence among different industries. Import depen-dence can be studied particularly closely because the input-output table hascomnlete data on the imports of each of the 396 inputs used by each of the 396producing sectors. The latest (1983) Korean input-output table was used,after updating based on a partial set of control data for 1986. Subsidiaryinformation on the origin of imports and exports (i.e. US, Japan, or other)

45/ For a detailed account of the Korean export promotion system, see Rhee,et. al. Korea's Competitive Edge (1984).

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was also available at the 396-sector level and used in various analyses.Details of the input-output model and its application are provided in Annex A.

4.37 High specialization implies that producers vary widely in theirpurchases of imports, depending on the particular characteristics of theirinput requirements. Import dependence is particularly high in the advancedmanufacturing sector, where sophisticated parts and components play a criticalrole. For example, imports account for 48 percent of the value of chemicalfiber output, 49 percent of iron and steel, 60 percent of electronicappliances, and 49 percent of electronic components. Disruptions to the flowof appropriate foreign inputs could be particularly damaging in these andother sectors at the upper end of the distribution.

4.38 In general, exports, import-substitution, and investment--the mostdynamic branches of Korean industry--are the most import-dependent activitiesof the economy. This is demonstrated in Table 5.8, which tabulates importdependence indexes by type of final demand. The Table also includes a columnlabelled "import substitution"-defined as the bundle of goods represented byKorea's manufactured imports. Import substitution is the most import-intensive of potential final demand activities (each dollar of importsubstitution requires 36 cents of imports), with investment and exports notfar behind (36 and 34 cents, respectively). Public investment, and privateand public consumption are substantially less dependent on foreign goods (18,19, and 14 cents, respectively), partly because they require fewertechnologically advanced products, but partly also because Korean consumersface higher tariff and non-tariff barriers than either investors orexporters.

Table 4.8: DIRECT AND INDIRECT IMPORT REQUIREMENTS OFDIFFERENT TYPES OF FINAL DEMAND

(percentages)

Requirements: Imports Imports Importsfrom from from Total

Type of demand US Japan others imports

Private consumption 3.1 3.3 7.8 14.2

Government consumption 5.1 4.7 8.7 18.5

Private investment 6.2 16.3 13.4 35.9

Government investment 2.8 5.4 9.6 17.8

Exports to US 7.7 11.8 14.3 33.8

Exports to Japan 5.4 8.1 16.6 30.1

Exports to others 6.9 11.3 16.2 34.4

Import substitutes 7.1 11.7 17.6 36.4

Source: Calculations with 1983 input-output table, updated to 1986.

- 88 -

FIGURE 4.5IMPORTS BY SHARE OF IMPORTS IN DEMAND

60

50

~40

300

E-4

0.1 0.2 0'.3 0.4 0.'5 0.6 0.7 0.8 0.9 l'.O'

Ratio: Imports/Demand -

FIGURE 4.6IMPORTS BY SHARE OF US ANNi JAPAN

26

24- X

020-

0 4)

E- 12_ -7

'44U) 10

04 I

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Ratio: US/(US + Japan)

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4.39 Dependence on imports from the United States is highest in Koreanexport and import substitution activities, and on imports from Japan ininvestment. Significantly, each $1 billion exported to the US raises importsfrom Japan by $118 million, while each $1 billion exported to Japan raisesimports from the US by only $54 million. In fact, a $1 billion export toJapan induces more imports from Japan itself, of $81 million. The reasons forthese asymmetries have been already discussed; it is clear that they areempirically important.

4.40 But the specialized structure of import dependence is ultimately itsmost interesting and important feature. An import dependence ratio of 40percent could mean, at one extreme, that 40 percent of each type of input in agiven activity originates abroad. It could also mean, however, that 40percent of inputs originated entirely abroad, while the other 60 percentoriginated entirely domestically. In the first case the possibilities forchanging import dependence--that is, the elasticity of imports--will begreater, since there is evidence that adequate domestic substitutes alreadyexist in the required input categories.

4.41 Korea's import pattern is closer to the specialized extreme--most ofits imports have limited domestic substitutes. Figure 4.5 plots imports as afunction of the proportion of a specific type of demand that is satisfied fromimports. (By "specific type of demand" is meant the purchase of a particularinput by a particular producing sector of the input-output table, that is, thevalue of a given cell of the table.) Evidently more than 50 percent ofimports consists of products that are bought entirely from abroad, presumablyfor lack of effective domestic substitutes.

4.42 Furthermore, the partner-composition of Korean imports is also.extensively specialized. Figure 4.6 is similar to Figure 4.5, but shows thedistribution of imported products by whether they are received from the US orJapan. The two extremes of the Figure represent products in which supplyoriginates entirely in the US (left extreme) or entirely in Japan (rightextreme). Some products are purchased from both sources, but the bulk (66percent) of Korean imports consists of products that are at least 80 percentdominated by one country. Tais result implies inelasticities also inswitching imports from Japan to the United States; in a wide range of productsimported from Japan there does not appear to exist, at present, significantcompetition from US substitutes.

4.43 The principal finding of this analysis is that imports play acritical, and highly specialized role in Korean economic structure. Fuels andbasic raw materials aside, they are concentrated in the economy's mostadvanced sectors, including exports, investment, and import-substitution.Within the input structure of a particular subsector, imports are generallyconcentrated in. a few categories, and are frequently the dominant source of aparticular input. Finally, most imported inputs are obtained either from theUnited States or Japan, but seldom in significant quantities from both simul-taneously. The high level of specialization may be due to efficientindustrialization, or high, selective protection--or possibly both. Be thatas it may, great specialization makes it difficult to alter trade patterns;interventions designed to affect the volume and partner-composition of importswill be hampered by low short-run elasticities of response.

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V. POLICIES TO MANAGE TRADE FRICTION

A. Perspectives on Trade Management

The Need for Trade Management

5.1 Ideally, policies to manage bilateral trade should be unneccessary,since a country's bilateral trade balances have little significance foreconomic welfare. The structure and balance of bilateral trade are merelybyproducts of the comparative advantages of a country and its tradepartners. Thus, the fact that Korea's comparative advantage patterns arepartly due to its economic proximity to Japan may be of historical interest,but does not alter the economic logic of its trade. To be sure, bilateraltrade patterns are also affected by policy, and Korea has certainly notexhausted the possibilities for import lT,eralization. But even under themost open of trading arrangements, large bilateral imbalances would naturallydevelop given the present economic structures of Korea, Japan, and the UnitedStates.

5.2 In practice, however, theoretical arguments notwithstanding, Koreafaces great pressure from the United States to contain its burgeoningbilateral surplus. The implied threat of diminished access to US marketscannot be ignored in the formulation of Korean policy. The most urgentobjective of trade management, then, is to preserve and improve foreign marketpenetration without triggering protection. In analytical terms. at some levelof exports (above some unknown treshhold) the US demand curve {or Koreanexports becomes sharply downward-sloping, not because of tlhe intrinsicbehavior of market agents, but because of the likely imposition of protectivebarriers. The trade manager has to develop an optimal export strategy, muchlike the monopolist facing downward-sloping demand has to determine an optimalproduction point.

The Economics of Trade Management

5.3 The objectives of trade management have been cast in a new light bysome relatively new, and still controverstg), analytical developments in thefield of international political economy.. Since this discipline addressesinteractions between economic forces and political events, it can provideinsights concerning the causes of trade friction. In principle, tradefriction could develop in any significant bilateral trading situation, but thefact is that it tends to be intense only in situations of highly imbalancedtrade. It is important to understand why this happens and what it implies forpolicies designed to control friction.

46/ A review of such developments is provided in Krugman (1987).

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5.4 There are three reasons why imbalanced trade leads to conflict:

(a) It is easy for policy makers and voters on the deficit side of anasymmetric trading relationship to argue (and believe) that theyhave been more generous in granting access to their markets than thesurplus country.

(b) The deficit country has a disproportionately larger threat than thesurplus country. If bilateral trade were to be restricted, it wouldbe usually (but not always) less costly for the deficit country toreplace its imports than for the surplus country to find alternativeexport markets. Thus, the deficit country can threaten protec-tionist action with little concern about retaliation.

(c) Political pressure for bilateral protection is greatest when tradeis unbalanced because domestic interests significantly injured byimports (import-competing producers) outnumber (or outweigh) thosethat benefit from exports. Other interests that benefit frombilaterally unbalanced trade--consumers and exporters to thirdcountries--are too diffused to counter the interests of thosedirectly affected.

5.5 These factors are obviously at work in the present US-Koreaneconomic conflict, especially because Korean trade gains are often coming inUS industries such as automobiles, steel, and advanced consumer goods thathave been already politicized by earlier conflicts with Japanese competi-tors. Indeed one can argue that the second wave of imports will be hit harderthan the first wave since protectionist forces have learned from past failure.

5.6 The anatomy of trade friction suggests that a growing bilateraltrade surplus increases the likelihood of foreign protection. In turn, as thelikelihood of protection increases, exporting becomes subject to a negativeexternality: competition among individual exporters could trigger protectionwhich ultimately injures them as a group. The core of the problem is that theprofit-maximizing decisions of individual firms will not take into account thefull adverse effects of foreign protection. When a firm considers expandingits exports, it will ignore possible losses to other firms (in the event ofincreased protection) in deciding on the appropriate level of exports. Inthis setting, the collective behavior of firms will drive exports beyond thethreshold that triggers additional protection-to the disadvantage of allexporters.

5.7 This externality provides a rationale for Government intervention inan export drive that threatens to trigger protection. Such interventioncannot normally be justified in the absence of a significant protectionistthreat. And even if there is a protectionist threat, intervention would beunneccessary if protection consisted of several separate threats against firmsapproaching independent export treshholds. In the face of such "private"threats, firms would individually develop export policies that optimizedmarket access subject to the threat of protection. There is considerableevidence that Korean firms are aware of protectionist threats in their ownindustries and are ready to take defensive actions such as foreign investment

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and lobbying. Unfortunately, however, in the present legislative environmentthe greatest protectionist threat derives from overall perceptions ofUS-Korean trade relations, and is not triggered independently in varioussubsectors by specific cases of injury.

5.8 Clearly, then, there is a qualified theoretical case for trademanagement (see Krugman, 1987). It should be emphasized, however, thatrestrictions on exports can be very costly in the long term, particularly inindustries where high capital costs and/or rapidly declining learning curvesgenerate fierce competition for market shares. Inevitably, export managementdraws the government into difficult economic judgements about which exportsshould be encouraged to grow or decline. Thus, even if trade management canbe justified abstractly, its practical implementation can still create moredistortions than it cures.

5.9 To the maximum extent possible, trade management should be imple-mented with neutral instruments. The most desirable instrument is importliberalization, which not only helps to relieve foreign protectionist pres-sure, but also helps to improve the Korean incentive structure. Liberaliza-tion builds foreign interest in Korean trade relations and defuses protec-tionist instruments that are legally contingent on findings of "unfair"trade. Together with liberalization exchange rates need to be set at appro-priate levels as suggested by both trade management and other macroeconomicobjectives. The proper valuation of the exchange rate also removes distor-tions that would otherwise cause the economy to invest excessive resources inthe production of tradable commodities.

5.10 In some cases liberalization and correct exchange rate policy maystill leave politically unacceptable bilateral imbalances. In such cases,partner- and product-specific measures may be also necessary, despite the factthat these instruments inevitably introduce new distortions in the favor ofparticular imports and or sources. Discriminatory policies applied againstimports may also be problematic under international trading rules.

5.11 Even among selective measures there are gradations with respect toeconomic efficiency. For example, measures that rely on a general surchargeor subsidy on trade with a particular partner, without discriminating amongproducts, would impose lesser distortions than those that provide restrictivetreatment for specific export commodities. But even product-specific inter-ventions may be appropriate when general protection is more likely to betriggered by growth in some exports rather than others.

5.12 Empirical analysis of the determinants of protection suggests thatfactors such as the size, labor intensity, and rate of growth of the import-competing industry are correlated with the likelihood that protection will begranted (Lavergne, 1985). To the extent that this model is correct, exportrestraints designed with the determinants of protection in mind may be moreefficient in heading off trade conflict than general approaches aimed atrestricting bilateral trade. It should be observed, however, that thedeterminants of protection are not well understood, and that a product-specific approach increases the possibility for costly distortions andencourages rent-seeking. On the whole, a product-specific approach to trade

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management seems far too risky given the present state of knowledge aboutinduced protection.

B. Exchange Rate Management

Exchange Rate Policy and Bilateral Trade

5.13 Because of its wide-ranging effects, the exchange rate instrumentshould be set primarily to achieve an appropriate overall current accountposition and other macroeconomic objectives. Since the optimal size of theoverall surplus is not analyzed in this Report, no judgments can be made withrespect to the optimal value of the exchange rate. Nevertheless, since thepresent surplus exceeds government targets, it is likely that some combinationof trade liberalization and exchange rate measures will se required to bringthe overall surplus in line with policy. The main concern in the presentcontext is how appreciation might affect trade conflict. Unfortunately, thereare very few estimates of the effect of exchange rate changes on bilateralimbalances, and the estimates developed below are imprecise. Nevertheless,the best available evidence suggests that bilateral frictions wouldsubstantially diminish if the overall trade surplus were reduced.

5.14 The estimates reported in this section are based on the input-outputmodel described in the previous section and in Annex A. This model wasequipped with plausible trade elasticities in order to trace the effects ofvarious price-related policies. The analysis relies on plausible values basedon previous estimates for other countries and takes Korean circumstances intoaccount insofar as it relies on the trade and industrial structure dataembedded in the input-output system. Overall, the simulations should beviewed as providing broad, relative magnitudes, and not precise estimates.However imperfect, these results represent the only available quantitativeassesmesst of the effects of exchange rate and other policies on bilateral

5.15 According to the input-output model, a general real appreciation.(appreciation corrected for changes in the price level) of the won of 10percent would result, in the long run, in a $4.4 billion reduction in theKorean trade surplus. Such a depreciation would have completely eliminatedthe 1986 surplus, but due to the growth of the economy and other factors the"base" surplus for 1987 will be $3-4 billion higher. Government, KoreanDevelopment Institute (KDI), and Korea Institute of Economics and Technology(KIET) experts on exchange rate effects generally use the "rule of thumb" that

47/ Even though the model uses plausible "international" values forelasticities of substitution in such product categories as primarymaterials, capital goods, and consumer manufactures, the overallelasticity results do reflect country-specific data on importcomposition. The method would therefore predict lower importelasticities for Korea than, say, the US, because Korean imports consistprimarily of low-elasticity primary and capital goods, while US importsconsist mainly of high-elasticity consumer goods.

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a 10 percent appreciation will reduce the trade surplus by much less-around$2 billion. However, this estimate seems to be a short-run effect of anominal exchange rate change, viz., it measures only fairly rapid responsesand assumes that the appreciation is partly eroded by reduced domesticinflation, leading to a much smaller real appreciation. The 10 percent realappreciation simulated in this study would reqgure a substantially larger(perhaps twice as high) nominal appreciation."_

5.16 Appreciation has very different effects on exports and imports.Exports are reduced with an elasticity of approximately 1.4. Surprisingly,however, imports decrease with appreciation; the price effect in favor ofimports is actually outweighed by the diminished demand for imports in the(declining) export industries. This result is not due to the fact that smallimport elasticities were assumed; indeed, the average substitution elasticityused on the import side of the model was only slightly lower than the averageelasticity applied on the export side. Rather, it is a result of thespecialized pattern of Korean imports, as already described in Figures 4.5 and4.6. Even with moderately high substitution elasticities, significant importgrowth cannot occur in applications already dominated by imports, whichaccount for over half of all Korean imports.

5.17 Appreciation thus moves both US and Japanese bilateral balances inthe desired direction--that is, closer to balance. In the case of the USsurplus the effect is particularly pronounced: a 5.3 percent real apprecia-tion would generate a $1 billion reduction in the surplus. In other words,nearly half of the change in the overall surplus would register in thebilateral surplus with the United States. This effect, could sharply reducethe need for bilateral policies in the event that a reductioni in the overallsutplus is itself desired. The effect on the deficit with Japan iscons.A--ably smaller, since imports from Japan do not increase, and exporteffects are relatively small due to smaller price elasticities in Japanesemarkets and a lower initial volume of trade. It is worth reiterating,however, that these estimates are imprecise and subject to statisticalqualifications. In particular, it should be noted that they apply only tomarginal changes and may not be accurate for large, discrete changes in theexchange rate.

5.18 Table 5.1 also examines two hypothetical policies specifically aimedat altering bilateral trade: a trade subs idy 97 imports from the United Statesand a trade surcharge on imports from Japan. N either of these hypotheticalpolicies has been actually considered by Korean policy makers (nor does thisreport suggest that such policies be considered), but the policies provide a

48/ A comparison of alternative estimates of Korean trade price elasticitiesis provided in Annex A.

49/ This could reflect a policy configuration which included lower tariffs onUS-dominant imports like consumption goods and higher tariffs on Japan-dominant imports like producer goods; if so, it would involve a clearshift in domestic priorities between consumption and investment.

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simplified, analytic equivalent to more subtle, product-specific efforts toincrease US imports and switch sourcing from Japan to the US. Both measureshave the expected effect, but as Table 6.1 shows, neither is particularlypowerful. The reason for this is that both the subsidy and surcharge alterna-tives work on imports rather than both imports and exports. As alreadyargued, Korean imports are specialized and, subject to the present configura-tion of tariff and non-tariff barriers, are not very sensitive to marginalchanges in prices. Another important result is that neither the US subsidynor the Japanese surcharge, taken individually, is effective against the twinproblems of the US surplus and the Japanese deficit. In each case, most ofthe switching involves third trading partners--perhaps Europe or other EastAsian suppliers.

Table 5.1: SIMULATED EFFECTS OF HYPOTHETICAL POLICY MEASURES(billions of dollars)

CHANCES DUE TO: ----10% Real 10X Yen 10% subsidy 10% penalty

1986 Apprecia- Appre- on imports on importsItem Actual tion ciation from US /a from Japan /a

Total TradeExports 35.68 -5.12 4.08 0.16 -0.14Imports 31.46 -0.75 2.07 0.34 -0.46Net Trade 4.21 -4.36 2.02 -0.17 0.33

Trade with USExports 13.88 -2.07 0.73 0.07 -0.06Imports 6.54 -0.17 0.69 1.02 0.26Net Trade 7.34 -1.90 0.04 -0.95 -0.32

Trade with JapanExports 5.49 -0.58 1.08 0.02 -0.01Imports 10.91 -0.09 0.48 -0.30 -1.16Net Trade -5.41 -0.50 0.59 0.31 1.14

/a As explained in the text these are hypothetical and not actual policies;they are used in the table as heuristic devices to illustrate the effectof partner and product specific import regulations.

Source: Simulations with input-output model.

5.19 Table 5.2 restates these results, showing the effects ofhypothetical policy combinations. Since each policy is most effective againsta particular target, and there are three possible variables to be influenced(overall surplus, bilateral surplus with the US, and bilateral deficit withJapan) a combination of policies involving appreciation, subsidization of USimports, and surcharge on Japanese imports, will generally be most

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effective. An implicit recognition that a mix of policies is required isalready evident in the current Government initiatives discussed below.

Tab.e 5.2 SIMULATION RESULTS OF HYPOTHETICAL POLICIES

Real Subsidy on Surcharge onObjective appreciation US imports /a Japan imports /a

Reduce overall surplus $lb. 2.3% 58.8% -30.3%

Reduce surplus with US $lb. 5.3% 10.5% 31.3%

Reduce deficit with Japan $lb. -20.0% 32.3% 8.8Z

/a As explained in the text these are hypothetical and not actual policies;they are used in this table as heuristic devices to illustrate the effectof partner and product specific import regulations.

Source: Input-output simulations.

5.20 But the key point is that the cost of achieving bilateral tradegoals may be very large: a $1 billion reduction in the US trade surplus, forexample, would require a 10 percent subsidy on $6.5 billion imports, orGovernment expenditures of $650 million. This sum is not entirely lost to theKorean economy (much of it represents a transfer to Korean users of USimports), but it nevertheless represents a discouraging effectiveness ratio.It could be argued that these cost estimates are too high--that one couldcontrol the costs of import switching by applying subsidies only on themargin, to "new" imports from the United States. In practice, Government ismaking efforts to distinguish between of general and incremental imports inits import-switching incentive programs, but it is unlikely that these effortscan be successful in the context of a long-term, large-scale program.

C. Trade Liberalization

5.21 Korea is continuing to implement the liberalization program thatbegan in the early 1980s, although there is little evidence that the programis fundamentally changing imports. Four measures are currently beingadopted. First, a somewhat larger-than-scheduled group of 170 CCCN items wasplaced on the "Automatic Approval" list on July 1, 1987, bringing the overallimport liberalization ratio to 93.7 percent. Second, tariffs were lowered onover 200 CCCN items. Third, a decision has been made to eliminate the"surveillance list" over a two-year period. Fourth, Government has decided toundertake a review of special laws that continue to restrict trade even foritems on automatic approval.

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5.22 Automatic Approval Items. The net increase in the automaticapproval list is 168 CCCN items, with 170 being added and two removed from thelist. For the most part, the items correspond to those pre-announced in 1983,with some 12 items being delayed and 24 being accelerated relative to theearlier schedule. Since this is the fifth year of the program, the itemsbeing added are increasingly important and sensitive, with most falling intothe chemical and machinery categories.

5.23 It is difficult to estimate the effects of liberalization despitethe fact that better data are now available on the trade performance of itemsliberalized in the past. The fact is that these data do not show verysignificant effects. Table 5.3 provides import data for each of the fivegroups of commodities placed on the Automatic Approval list since July 1,1983. It appears that imports tend to grow rapidly at first in each of theliberalized groups, but subsequent growth is not unusual. To analyze thegrowth of liberalized imports relative to all imports, it is interesting toexamine the evolution of the share of liberalized imports in all imports. Forsome of the groups of liberalized commodities this share rises above its pre-liberalization value soon after liberalization, but for others it fluctuatesnear its original value or even declines. The average performance ofliberalized commodities offers no evidence of a significant effect even afterseveral years (see Figure 5.1).

Table 5.3: IMPORTS OF NEWLY LIBERALIZED COMMODITIES(millions of dollars)

Date LiberalizedJuly July Jan. July July1983 1984 1984 1985 1986

No. of items: 305 326 31 235 301

Imports in:1982 1st half 4761982 2nd half 447

1983 1st half 454 280 191983 2nd half 500 334 25

1984 1st half 714 526 29 4711984 2nd half 691 438 20 472

1985 1st half 642 436 23 483 1,0171985 2nd half 548 451 36 501 1,054

1986 1st half 615 575 - 648 1,3171986 2nd half 576 582 79 804 1,531

Source: Ministry of Trade Industry.

FIGURE 5.1IMPORT SHARE OF NEWLY LIBERALIZED ITEMS

1.8_1.7

1.61.5

- 1.4U 1.3

1.2 , .

1.1 IIN

0.8 ~0.7

s. 0.60.5

6 12 18 24 30 36 42

Months after Liberalization

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5.24 These findings are based on a relatively simple methodology, dnd itis always possible that more careful analysis would show a more dramaticeffect. For eample, the results could change if the growth of imports innewly liberalized groups was compared to the behavior of imports in someother, narrower reference group of "similar" products. At present, however,the data do not show larger increases in import penetration in liberalizedcategories as compared with other categories. One hypothesis cons' stent withthis finding is that liberalized imports continue to be closely constrained byother barriers--such as high tariffs or special laws.

5.25 Given uncertainty about the effects of liberalization, thequantitative illustrations presented below assiune that placement on automaticapproval status increases imports by 10 percent above what they would havebeen in the absence of liberalization. The 1986 value of trade in theliberalized categories is presented in Table 5.4. Under the 10 percentincrease assumption, the trade effects of liberalization are estimated inTable 5.5 at $158 million.

Table 5.4: VALUE OF IMPORTS IN CATEGORIES SUBJECT TO LIBERALIZATION(millions of US dollars)

1986 tradeNewly Items Tariff AverageLiber- on sur- cut tariff

Total alized veillance items cutSector trade 7/1/87 list 7/1/87 7/1/87

Total 31,543 1,580 720 318 4.4

Primary, food, beverages 9,656 19 184 49 4.2Chemicals, ceramics 5,199 227 73 74 4.0Metals and products 3,264 19 252 0 -Non-electrical machinery 6,290 558 100 82 4.5Electrical machinery 5,417 454 31 111 4.6Textiles, leather 1,494 142 77 0 -Miscellaneous 223 161 2 0 3.7

Source: Ministry of Finance and Korean Traders Association.

5.26 Tarrif Reductions. Tariffs were reduced on July 1, 1987 on 210items, consisting of 157 cuts made primarily to reduce trade frictions, and 53cust made to contain price pressures. The concessional tariff reductionsinclude cigarettes (from 100 percent to 70 percent), photo films (from 25percent to 20 percent) and various basic chemicals (from 20 percent to 15

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percent). The average reduction is 9.5 percentage pointsj,/owever, the trade-weighted price effect of these reductions is 4.4 percent.-

5.27 Total imports for the items subject to concessional tariff cuts was$318 million in 1986, and using the input-output elasticities reported inAnnex B it is estimated that the tariff cuts will increase imports by $28million, including approximately $4 million from the United States. Since theimport-intensity of import substituting industries is around 36 percent, thenet trade effect will be only about two-thirds of the $28 millien estimate.These modest magnitudes notwithstanding, the tariff cuts represent animportant further step in the liberalization of Korea's trade system.

5.28 Surveillance List. Since the liberalization program began, Koreahas maintained a "surveillance list" of imports with a threatened importsurge. This list has included between 100 and 200 items in recent years; thepresent list contains 90 items and covered imports valued at $720 million in1986. Since the use of other safeguard measures has been extremely judicious,the surveillance list is the most important restriction on the imports ofautomatic approval items, excepting special laws (on which more below). Theeffect of having product appear on the surveillance list is unclear; however,the appearance of an item on the list apparently affects the likelihood thatan import offer agent (a necessary intermediary in the importation process)provides the clearances necessary to effect imports. Guidance on importscomes from the relevant industry association.

5.29 On the assumption that the surveillance list would be phased outcompletely over a two-year period, it is reasonable to expect as much as a 25percent increase in imports in the items now on the list. This very roughestimate is used in Table 6.5 to quantify the potential effects of eliminatingthe list.

5.30 Special Laws. As many as one-quarter of the items on automaticapproval are subject to special laws which circumscribe or prohibit theimportation of certain items. The role of special laws has been singled outin past World Bank reports, and in a recent paper by the American Chamber ofCommerce on Korean trade restrictions. The trade-restraining effect of theselaws cannot be estimated within the scope of the present exercise, nor is itclear to what extent the laws could be relaxed without undermining theirobjective of protecting health and safety.

5.31 Sum of Liberalization Effects. Overall, the 1987 liberalizationprogram involves sound steps in increasing automatic approval items andreducing tariffs, and promises to eliminate, over time, some important

50/ For example, a tariff reduction from 50% to 40% represents a 10percentage point reduction in the tariff, but the price after thereduction, 140% of the world price, is only 6.7Z below the 1501 pricebefore the reduction. A further round of tariff reductions has beenannounced for January 1988; 171 import items are to be cavered and thetariff cuts will range from 3 to 20 percentage points.

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informal barriers. If special laws are excluded from the analysis, however,the program covers only about 7 percent of imports, and is likely to generateincreased trade only on the order of $366 million, or about 1 percent of 1986imports (see Table 5.5). The net trade effect will be smaller, to the extentthat these imports will reduce production in highly import-intensive domesticimport-substitution activities. Due to the benefits of liberalization for theKorean economy, it is desirable that the liberalization measures continue toreceive priority among policy measures being undertaken to improve the traderegime, even if it is not the panacea to the problem of current tradeim,balances.

Table 5.5: POTENTIAL IMPORT EFFECTS OF LIBERALIZATION(millions of dollars)

Newly Items Tariffliber- on sur- cutalized vlvillance items From From

Sector 7/1/87 !ist 7/1/87 Total US Japan

Total 158 180 28 366 71 153

Primary, food, beverages 2 46 4 52 12 1Chemicals, ceramics 23 18 6 47 10 20Metals and products 2 63 0 65 11 31Non-electrical machinery 56 25 7 88 17 44Electrical machinery 45 8 10 63 15 37Textiles, leather 14 19 0 33 3 13Miscellaneous 16 1 0 17 3 7

Assumptions: Liberalization increases imports 1OZ in items added in 1987;elimination of surveillance list increases imports 25X; tariffcuts increase imports with an elasticity of 2.0. US andJapanese shares are allocated on the basis of their existingshares in each category.

5.32 The bilateral effect of liberalization has been the subject ofconsiderable debate, with studies addressing the issue being prepared by boththe Korean and US Governments. It appears that the list of commoditiesliberalizell)'ncludes many in which Japan enjoyed a substantial tradeadvantage.- While there is no purely economic rationale for focusingliberalization on imports from particular trade partners, it is possible that

51/ It should be noted that 270 of the 330 items which will remain restrictedafter the final round of the currently planned liberalization in July1988 are agricultural, a category in which the US has a distinctcomparative advantage.

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partner-specific liberalization might still be desirable compared to other,more distorting policies undertaken for trade diplomacy purposes.

5.33 Trade liberalization has so far not resulted in much increase ofimports. This outcome may be attributed in part to the nature of the items sofar liberalized but also in part to the export-oriented environment in whichliberalization has occurred. Importation is probably not viewed with greatsympathy at present unless it furthers an export aim. Indeed, this is theresult of highly successful policies pursued for decades and it may take timeto reverse. Nevertheless, for trade liberalization to work, an import-friendly environment (viz., including distribution channels) may have to becultivated as an integral part of the trade liberalization program. Thisbeing said, the responsibility of potential exporters to learn about domesticretailing customs and rules and to learn how to exploit local purchasingpreferences is clearly of paramount importance as well.

D. Other Measures

Localization

5.34 A localization program has been recently adopted to initiate orincrease domestic production of long list of imported commodities. Theselected commodities have been surveyed by the Korean Traders Association anda two- or five-year schedule has been developed for eliminating imports andincreasing exports in each commodity. The list currently contains 704 items;there are apparently plans to add a similar number of items each year, and afive-year program announced in December 1986 includes some 2530 commodities.

5.35 An important goal of the program is to reduce the bilateral tradedeficit with Japan. The 704 items currently listed involved imports of $710million (data are only available for 1985), with $360 million from Japan. Inaddition, the program also seeks to "deepen" Korean industrial structure,particularly in upstream suppliers of the automobile and electronicsindustries. All but 64 of the 704 items involve parts and components in themachinery, automobile, shipbuilding, and electronics subsectors.

5.36 Beside helping to identify items and set localization targets,Government is offering financial support. A foreign currency loan fund ofapproximately $2.5 billion has been recently made available for localization(as well as other programs described below). Since foreign funds are lent toKorean firms at only 1.5 percent above LIBOR (usually for a period of 10years), they are very attractive due to the likely future appreciation of thewon. Indeed, at current interest rates plus probable appreciation they bearan expected nominal interest rate of zero, and an expected real rate ofnegative 4-5 percent. The use of this facility began in May 1987, withreportedly $271 million made available by end-June 1987.

5.37 Various other sources of funds are also available for localization,although it is unclear to what extent they are committed to this single policyobjective. These funds include a total of 342 billion won ($420 million) fromthe Technology Development Fund of the Korean Development Bank, the Small andMedium Industries Bank, the Exporting Industries Facilities Fund, the National

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Investment Fund, and other facilities. In addition, some 1,700 billion won($2.1 billion) are reported to be available on the "demand" side forpurchasers of localized capital goods.

5.38 Some empirical evidence on the operation of localization in 370items that were scheduled for localization over the 1986-1987 period isreported in Table 5.6. Overall, $395 million will have been invested in therelated localization programs with more than two-thirds of the effort concen-trated in the parts and components area (see Table 5.7). As of the present,nearly half of the projects were financed by retained earnings of thecompanies involved, while 19 percent and 7 percent coming from governmentfunds and foreign loans, respectively. In the past, at least, indirectsubsidization through access to foreign exchange loans has been very modest.And while Government continues to influence bank lending decisiors (the sourceof 29 percent of the localization funds in the past), it is evident thatsubstantial private capital is also involved in the localization program.

5.39 The trade effects of localization have been estimated in some detailby a Korean Traders Association study of the 370-item experience with thelocalization program. It is projected that by 1990 import savings will amountto more than $1 billion, and additional exports to $795 million (seeTable 5.6). These are ambitious goals when compared to historical imports andexports in the items identified, but the products represent important inputsto key Korean industries whose output is likely to rise. Still, in thecontext of the Korean economy as a whole, even the generously-projected scopeof the program amounts to no more than 1-2 percent of trade and investment.

t.40 Given the recent appreciation of the yen, significant localizationis bound to occur without any special publicity or incentives. This trendwill be reinforced also by the maturing structure of Korean industry. Thus,the localization program is not only modest, but it is also probablyunnecessary. Moreover, localization works at cross-purposes with other policyinitiatives that are designed to eliminate restrictions to imports, containKorea's trade surplus, and reduce Government intervention in the economy. Thelocalization program is also a prominent example of subsidized importsubstitution and a continuing source of trade friction with the UnitedStates. On the whole, the localization program's general import- substitutingojectives and detailed, product-specific implementation are inconsistent withrecent Korean policy trends and Korea's maturing position in the worldeconomy.

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Table 5.6: PROJECTED TRADE EFFECTS OF LOCALIZATION OF 370 ITEMSIDENTIFIED FOR LOCALIZATION PRIOR TO 1987

(million of US dollars)

Import substitution Export substitutionSector 1987 1988 1989 1990 1987 1988 1989 1990

Total 420 713 966 1,099 154 290 395 795

Machinery 55 96 112 123 15 35 43 51Machine parts 70 122 163 172 10 27 39 42Auto parts 48 58 70 70 20 26 29 29Ship parts 25 41 45 49 7 13 17 250Electronics 126 230 313 372 75 142 192 309Materials 86 155 252 302 23 43 71 110Other 10 11 11 11 4 4 4 4

Source: Korean Traders Association.

Table 5.7: INVESTMENT IMPLICATIONS OF LOCALIZATION OF 370 ITEMSIDENTIFIED FOR LOCALIZATION PRIOR TO 1987

(billion of won except as noted)

TotalNumber projected Earnings Govern- Banks Foreign

Sector of items investment (Z) ment (Z) (X) Loan (Z)

Total 370 395 45.2 19.0 29.1 6.7

Machinery 61 29 45.3 23.6 25.5 5.6Machine parts 70 38 46.1 24.3 20.0 9.6Auto parts 46 37 45.1 14.1 33.8 7.0Ship parts 37 17 44.1 18.6 25.4 11.9Electronics 99 120 45.1 17.9 34.0 3.0Materials 52 154 44.8 13.8 34.5 6.9Other 5 n.a. 44.4 11.1 33.3 11.2

Source: Korean Traders Association.

Diversification

5.41 Government has announced two lists of imported products which ithopes will be switched from Japan to other suppliers, including the UnitedStates. One list contains 235 so-called "voluntary" diversification items,

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and another 162 "compulsory" items. Together, these lists contain importsvalued at $17.1 billion, or nearly two-thirds of all imports. Japan's shareamounts to $9.9 billion, or approximately 90 percent of all imports fromJapan. The lists have been used in import missions to the United States andelsewhere as an example of export opportunities to Korea.

5.42 Unlike the localization lists, the diversification lists are nearlyall-inclusive. Thus, the diversification program does not appear to be highlyfocused, and is best viewed as a general attempt to raise consciousness aboutimport-sourcing. Indeed, effective incentives designed to accelerate importswitching in all of the listed commodities would require very substantialresources.

5.43 The $2.5 billion foreign exchange loan fund already mentioned isalso available to support import switching under the diversificationprogram. A very rough estimate of the effects of the program is provided inTable 5.8, which calculates the extent of import switching under the assump-tion that low-cost loans or other incentives are provided that effectivelyreduce the cost of imports from the US by 10 percent relative to imports from-Japan. The actual incentives likely to be offered will be almost certainlysmaller. With the 10 percent subsidy, however, approximately $397 million ofimports would be switched to US sources (using 1986 trade as a base). Thecost of the subsidy could be as little as $40 million, if the subsidy ispinpointed on the newly-switched imports, but could run to as much as $334million if all US imports in the categories identified benefit. Government ismaking some effort to identify "new" from old imports by relying oncertification from industry associations.

Table 5.8: POSSIBLE EFFECTS OF DIVERSIFICATION PROGRAM(millions of US dollars)

1986 imports 1986 imports Importsof voluntary of compulsory switched

diversification items diversification items by 10XTotal Japan US Total Japan US subsidy1 2 3 4 5 6 7

Total 5,988 3,340 1,112 11,061 6,382 1,823 397

Food, beverages 16 9 2 142 48 22 3Chemicals, Ceramics 1,380 530 332 2,597 1,132 572 107Metals and Products 604 452 51 1,149 913 80 22Electrical machinery 2,485 1,493 373 4,415 2,619 676 152Textiles, leather 31 14 2 583 274 44 7Miscellaneous 2 2 0 170 144 10 2

Note: Columns 1, 2, 4 and 5 from Korean Traders Association; columns 3 and 6estimated, column 7 calculated assuming substitution elasticity of 2.0 ineach category.

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5.44 To the extent that an economic (as distinct from diplomatic)rationale exists for diversification, it must be that imports from the US arelike "infant industries"--that is, suffer from some startup problems due tothe unavailability of information, after-service, and the like. It isunlikely that a strong case could be built for an across-the-board diversifi-cation program on the basis of such arguments. In addition, while such adiscriminatory program may be helping Korea's relationship with the UnitedStates, it is exacerbating frictions with Japan. On the other hand, it maystrengthen Korea's hand in gaining greater market access in Japan.

Voluntary Export Restraints

5.45 A recently popular instrument of Korean trade management is the"voluntary" voluntary export restraint (WVER). Export restrictions have beenimposed on a number of industries without explicit negotiations or foreignrequests (see Table 5.9). VVERs are currently in force against exports thattotaled $4.9 billion--amount to 35Z of all Korean exports to the UnitedStates. Including the 23 percent of exports that are covered by the Multi-fiber Agreement, this means that some form of export restraint now covers themajority of Korean trade with the United States. Although the combined roleof VVERs and the MFA is less important in other markets, there is no doubtthat Government influence over exports is dramatically rising.

Table 5.9: VOLUNTARY EXPORT RESTRAINTS TO THE US(millions of US dollars)

1986 January-March 1987Total To US Total To US

Export Value Growth Value Growth Value Growth Value Growth

TOTAL 9,367 27.0 4,914 27.9 2,498 38.2 1,185 24.6

Iron steel 2,489 -3.6 678 -18.1 516 -5.1 135 -10.6Footwear 2,109 34.2 1,501 30.3 546 22.4 329 2.8Containers 258 -7.9 157 -6.5 80 86.0 52 67.7Wigs 60 15.4 39 18.8 16 33.3 11 37.5Flatware 94 40.3 47 34.3 27 42.1 11 10.0VCR 551 166.2 335 - 184 142.1 86 87.0Microwave oven 442 108.5 298 72.3 132 59.0 83 40.7Color TV 534 42.4 258 44.1 190 91.9 67 24.1B&W TV 275 27.3 184 15.0 81 58.8 47 51.6Toys 566 65.5 427 61.1 141 64.0 100 51.5Pianos 90 66.6 48 50.0 30 100.0 18 100.0Kitchenware 134 27.6 69 21.1 38 40.7 15 7.1Polyester bag 230 42.9 131 32.3 68 61.9 38 65.2Leather apparel 588 41.0 253 19.9 181 108.0 58 75.8Furs 189 17.4 118 -4.8 39 39.3 22 29.4Baseball glove 50 0.0 31 -13.9 15 15.4 11 37.5Eyeglasses 62 47.6 32 33.3 22 69.2 8 33.3Personal items 216 52.1 99 26.9 70 79.5 30 76.5Leather bags 228 21.9 106 5.0 62 47.6 34 25.9Fishing rods 83 15.3 24 -22.6 25 19.0 10 42.9(untranslated) 62 63.2 42 55.6 19 90.0 10 66.7Brassware 57 39.0 38 22.6 16 45.5 10 25.0

Source: Ministry of Trade and Industry

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5.46 The operation of VVERs in the products listed in Table 9 is not welldocumented. It is clear from recent export data that the VVERs are havingsome effect on 1987 exports, since the recent data now show a much more rapidrise in Korean exports of the restricted products to markets other than theUnited States. Yet little is known about how the exports of individualproducers are allocated, or what incentives are available for obtaining thecooperation of the private sector. Some of the control presumably involvesthe availability of bank loans, which continue to be somewhat cheaper thanother sources of funds. The leverage exerted to control imports must besignificant to be effective, since market share competition is very keen in anumber of industries covered by WVERs.

5.47 Additional VERs (or VVERs) are also being requested by Japan. Therapid penetration of Korean exports particularly in apparel has raised concernin Japan, since access to the Japanese market is not formally restrictedthrough the MFA. According to both Korean and Japanese sources Japan has madeit clear to Korea that unless it slows penetration into Japanese marketsimport controls may be adopted.

5.48 In the short run, WVERs represent a quick and certain instrument foralleviating trade friction. In the long run, however, they have complex andfarreaching implications for industrial srructure. An effective WER programwould involve Government in detailed moni.oring and intervention in some ofKorea's most important new industries. This makes it a risky policy indeed,for Government will be deciding, in effect, international growth and marketingstrategies at the leading edge of Korean industry. In fact, Governmentinvolvement will itself complicate private decision-making since it will makeit necessary for firms to adopt strategic policies to try to obtain shares inKorean exports. Firms may even enter industries where they would be otherwiseuncompetitive, for the purpose of reserving future export claims. In thisstrategic context, Government will also suffer from inadequate information,since firms will have a strong incentive to distort information that relatesto their costs and competitiveness.

5.49 Furthermore, VERs seldom work. When large profit opportunities arecreated by one country's VERs, other countries typically expand theirexports. In the end, the foreign market is not protected, but merely shiftedto other competitors. This is a strategy that Korea itself pursued with greatsuccess in the past when VERs were adopted in Japan on steel, color televisionsets, and automobiles.

5.50 The rapid proliferation of VERs illustrates the difficult tradeoffsthat foreign protectionism imposes on Korean policy. As argued earlier,independent private decisions can be suboptimal in the context of contingentforeign protection. Yet the defensive control of exports can also lead toserious distortions--Government is not equipped for intricate, strategicdecision-making in the international marketing of new and sophisticatedproducts. The fact that such serious disadvantages are associated with VERssuggests that other, more neutral measures to manage trade should bevigorously pursued and exhausted before VERs are imposed.

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Defensive Investments Abroad

5.51 So far, this survey has concentrated on Government policy. Privatefirms, however, are also conscious of the threat of protection and are takingsteps to protect foreign markets. Their efforts are concentrated on develop-ing foreign constituencies that have a stake in importing from Korea. Asidefrom direct political lobbying, this can be done by acquiring influentialforeign partners (Daewoo's strategy in the US automobile and micocomputermarkets) or building manufacturing plants in the foreign market (Hyundai'sstrategy in Canada).

5.52 There are no separate statistics on "marketing partnerships,"although clearly marketing agreements with General Motors and Ford will beimportant in Korean automobile sales in the US. As of a 1985, Koo and Lee(1985) report little defensive foreign investment, mostly concentrated inproducts such as golf bags and color television sets. More recently the paceof manufacturing investments in developed countries--the likely site ofdefensive assembly operations--has accelerated. Recent examples include aHyundai assembly plant in Canada, a Gold Star microwave oven plant in Alabama,and Gold Star and Samsung television receiver plants in the United States.Significantly, Korean exporters are behaving quite differently from Japanesefirms at a similar point in their exporting history: Japanese firms seldomentered into marketing partnerships and only recently begun to establishassembly facilities abroad.

5.53 Among export-preserving strategies it is too early to tell whetherdirect investment abroad or close collaboration with a foreign partner is themore effective. It is clear, however, that it is in Korea's interest toencourage private experimentation, because ultimately the individual exporterhas the greatest motive to avoid, and best information about, protectionismabroad. As already argued, private response alone would be sufficient andoptimal if there was no "cumulative" export treshhold behind the protectionistthreat--that is, if each exporter's threat was independent of the actions ofother exporters.

E. Recommendations

5.54 The intensification of trade frictions is the logical, ifundesirable, byproduct of the remarkable turnaround in Korea's externalaccounts from periodic crises to fundamental strength. Stresses have emergednot only in trade with the United States, but also in Korea's trade relation-ships with Japan. Since these pressures have not been fully addressed withexchange rate policy, the policy goals of (1) containing inflationarypressures, (2) controlling trade conflict with the United States, and (3)reducing the trade deficit with Japan, have been pursued with a wide range ofimperfect ad hoc instruments.

5.55 The policy goals themselves are reasonable, since there isanalytical rationale for managing bilateral trade: private trading decisionscan affect national welfare adversely in an environment of contingentprotection--that is, if foreign protectionism is triggered by trade sur-pluses. Government action to head off protection is then justified, even if

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it involves sourcing and marketing results that cannot be justified ontraditional economic grounds. As with all second-best policies, however,extreme care must be used in acting on this justification. The critical test,in the present case, is whether the protectionist threat significantlythreatens producers other than those seeking to expand exports or the produc-tion of import substitutes.

5.56 As the new policy objectives of trade management are added to thepolicy agenda, it is natural to seek new tools in addition to general macro-economic instruments. As this survey has shown, a variety of tools are nowbeing developed, with mixed effects on the economy and chances for success.Two somewhat surprising conclusions emerge. First, the neutral policy ofappreciation has been found to have a large impact on at least the surpluswith the United States. Second, some widely-publicized ad hoc instrumentswere found to have relatively small effects--unless they are pursued veryvigorously and at great cost. Overall, these findings suggest that the roleof liberalization and exchange rate policy should be increased relative tothat of the "new" microeconomic instruments. These choices are desirable not

; just because of its effect on trade flows, but also because of their generalpositive implications for future industrial, trade, and macroeconomic policy.

5.57 The analytical findings of this study lead to a number of morespecific recommendations on policy:

(a) Government intervention should focus primarily on the liberalizationof existing trade restrictions. Today's strong current accountposition provides in unprecedented (in Korea) and unusual (in theinternational context) opportunitV for opening markets. Liberaliza-tion efforts elsewhere have failed precisely because of the absenceof a supportive macroeconomic environment. Korea's strong externalposition and rapid economic growth provide an extraordinary oppor-tunity for implementing aggressive liberalization measures. Inparticular:

(i) Rapid progress should be made on streamlining and/or elimi-nating special laws. These laws represent the most opaque and(probably) most restrictive element of Korea's presentprotectionist structure.

(ii) The surveillance list should be critically reviewed as it mayhave outlived its usefulness.

(iii) Tariffs and other taxes levied on imported consumer goodsshould be reduced. Charges on imports are very high in anumber of categories, recent adjustments notwithstanding.Further cuts are needed to raise Korean living standards andimprove the efficiency of the economy.

(iv) Liberalization should be targeted to reduce trade imbalanceswith the United States. Addressing trade diplomacy problemswith liberalization (a trade-increasing solution) is muchpreferable to the adoption of (trade- decreasing) alternatives

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such as voluntary export restraints. Unfortunately, prospectsfor success in this area are limited, althrough there arehighly visible areas for reform, such as agriculture.

(v) An effective safeguards mechanism should be developed to takethe place of the surveillance list. An open and visibletemporary protection scheme can accelerate liberalization byproviding a safety net for seriously affected companies.

(b) Together with trade liberalization, the proper adjustment of the wonexchange rate should be considered, The appropriate level of theexchange rate is not the subject of this study--and indeed, willvary from time to time with changes in the value of the yen, oilprices, and the macroeconomic environment. To the extent that thevalue of the won generates macroeconomic and trade difficulties,appreciation would be desirable for several reasons:

(i) Macroeconomic stresses such as inflation could be reducedwithout adopting much more complicated and interventionistmicroeconomic policies.

(ii) Excessive investments and serious future adjustment problems inindustries that are not competitive at equilibrium exchangerates can be avoided.

(iii) The bilateral trade surplus with the US could be significantlyreduced with very favorable implications for Korean tradediplomacy.

(c) To the extent that direct microeconomic policies are needed tomanage trade conflict, private responses should be stressed ratherthan public ones. Firms that perceive threats to their exportmarkets will seek to minimize such threats through public relations,joint ventures, and defensive investments. These responses may becostly, but they are likely to be better tailored to actual threatsthan broader Government actions. To this end, Government should:

(i) Permit and encourage firms to experiment with alternativeapproaches to warding off protection, including investment inforeign assembly facilities and marketing joint ventures withforeign firms.

(d) If Government microeconomic intervention becomes necessary, neutralmeasures should be stressed rather than product-specific measures.Economic theory argues for interventions that directly address thesource of a particular externality and introduce the minimaladditional distortions. If a reduction in the bilateral surpluswith the US is required, the ideal policy will approximate theeffects of a uniform subsidy on imports from the US and a similartax on exports to the US. An actual tax-based approach is unlikelyto be implemented but it does provide a standard for evaluatingother policies. Product-specific departures from a neutral norm

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need to be justified clearly with reference to factors peculiar tothe product. In keeping with these criteria:

(i) Voluntary VERs should be used with great caution. Self-imposedexport restraints impact Korea's most rapidly growing exports--,.hat is, commodities in which Korea has a strong competitiveposition and is developing major world market shares. Forvarious reasons, it is extremely risky to manage Korea's tradebalance by controlling highly promising exports. At the sametime, it is clear that an effort to reduce bilateral tradeimbalances should include policies that affect the export sideas well as the import side.

(ii) The localization program should be unnecessary. Support oflocalization involves Government in a wide range of explicitdecisions about import-substitution. Most objectives of theprogram are likely to be accomplished anyway due to theappreciation of the yen, and the existence of the programcomplicates Korea's position in trade negotiations.

(iii) The diversification program should be used only as a lastresort. To the extent that diversification involves thedistribution of information at home and abroad about potentialsales opportunities, it should be vigorously pursued. However,significant import switching through this program would requirevery costly financial incentives. The program also exacerbatestrade tensions. Despite these drawbacks, however, the diversi-fication program is the most neutral of the direct interventionefforts that are currently being pursued, since it coversnearly all Korean imports.

As these recommendations show, there is considerable opportunity for stream-lining the mix of policies with analytical priorities. At present, too much

of the trade management effort is concentrated on microeconomic interventions,

and too much of this effort is focused on individual commodities. This is thecase with the three most visible programs that have been implemented: locali-zation, diversification, and voluntary VERs. These programs work at cross-purposes with Korea's general trade-opening strategy and confuse foreign

perceptions about the Korean liberalization effort.

5.58 A shift toward more effective and neutral instruments is clearlywarranted. In recommending this shift, it is recognized that trade diplomacyimposes constraints not only on actual policy but also on Government's public

communications. It is possible, for example, that product-detailed policy

announcements have greater credibility both at home and abroad than neutralexchange rate changes. This can partly justify the attention focused on

detailed action programs in the past. Yet the underlying problems will notdisappear on their own and need to be addressed with real solutions. Thesooner these solutions are implemented, the fewer Korean resources will be

invested into industries and activities that are not viable under equilibriumconditions. Korea has an unprecedented opportunity to open its markets, solve

its trade conflicts, and begin reaping the benefits that its recent successes

make possible.

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BIBLIOGRAPHY

Akhtar, M. A. Financial Innovation and Their Implications for MonetaryPolicy: An International Perspective. Basle, Switzerland: Bank forInternational Settlements, December 1983.

Anckonie, A. and C. H. Chi, Internationalization of the Korean Stock Market,mimeo, George Washington University, Department of BusinessAdministration, 1986.

Balassa, B. and J. Williamson, Adjusting to Success: Balance of PaymentsPolicy in the East Asia NICs, Policy Analyses in International Economics,No. 17, Institute for International Economies, June 1987.

Bank of Korea. Financial System in Korea. 1985.

Bockelman, H., "Current Problems of Monetary Policy in Germany" in A. Courakis(ed.), Inflation, Depression and Economic Policy in the West, Barnes andNoble, New Jersey, 1981.

Corbo, V. and S. W. Nam, :Controlling Inflation: The Korean Experience",World Bank Discussion Paper, 1986.

Courakis, A., Inflation, Depression and Economic Policy in the West, Barnesand Noble, New Jersey, 1981.

Dooley, M. and D. Mathieson, "Financial Liberalization in DevelopingCountries", Finance and Development, September 1987.

Foreign Bankers Group in Korea. Proposals for a Korean Money Market System.Seoul, Korea. February 1987.

Friedman, Milton. A Program for Monetary Stability. New York: FordhamUniversity Press, 1959.

Giavazzi, F. Exchange Controls and Sterilization: The German Experience andLessons for Korea, Mimeo, World Bank, 1987.

Hester, D. "Innovations and Monetary Control", Brookings Papers on EconomicActivity, 1981.

Krugman, P. "Is Free Trade Passe?" Economic Perspectives, 1:2, 1987.

Rhee, Y. et. al. Korea's Competitive Edge, Johns Hopkins Press, Baltimore,1984.

Ro, S. T. "Favorable External Conditions and the Korean Economy in 1986",Korea Development Institute. Discussion Paper, May 1987.

Salop, J. "Monetary Targeting in the UK" Finance and Development, December1986.

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Schlesinger, H. "Recent Experiences with Monetary Policy in the FederalRepublic of Cermany," in Kredit and Kapital, Vol. 12, 1979.

World Bank, Korea: Managing the Industrial Transition, 1986.

Petri, P.A. "Korea's Export Niche: Origins and Prospects" World Development,1988.

Lavergne, R. The Political Economy of US Tariffs, New York, Academic Press,1983.

Koot B.Y. and Lee, K. "Korean Direct Foreign Investment", Korea DevelopmentInstitute Working Paper, 1985.

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ANNEX A

An Input-Output Model of Korean Trade

Introduction

Chapters 4 and 5 of this study use an Input-output model of the Koreaneconomy to estiante relatlonships between trade and industrial output andto assess the effects of exchange rate and trade policy changes. Theprlncipal data sources included the 1983 input-output table, which has 396sectors, and 1986 trade data ln the same 396 sector detail. The trade datawere available separately for trade with the U.S., Japan. and the Rest ofthe World. and made it possible to disaggrega*e input-output trade resultsby partner. Data for the model were provided by the Bank of Korea and theKorean Trader's Association.

The 1983 table was roughly updated to yleld 1986 trade results, and thereported simulations were perforaed with the updated table. In addition,for conducting the exchange rate slmulatlons reported ln Chapter 6. theInput output table was equipped with various plausible price elasticityestimates.

The 396 industry sectors of the input-output system are given In Bankof Korea (1986). the official publication of the Korean input-output system.In addition to the 396 Industrial sectors, the lnput-output model used herehas the following final demand sectors:

1. Private Consumption2. Government Consumption3. Private Capital Formation4. Government Capital Formation5. Exports to U.S.6. Exports to Japan7. Exports to Rest of World

The aodel also includes the following basic inputs:

1. Domestic Value Added2. Imports from U.S.3. Imports from Japan4. Imports from Rest of World

The principal task of the model is to show how changes in final demandand input decisions (e.g. between domestic and imported inputs) affect thedemand for "baslc" inputs. i.e. domestic value added and various categoriesof imports. Such relationships are tabulated, for example. In Chapter 5.Table 5. Several simulations of the model were conducted to estimate theeffects of exchange rate changes and other trade policies. These sloulationsInvolve changes In final demands (exports) as well as input-output coefficients(import coefficients),

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The Basic Model

The input-output model predlcts import requirements using a well-known relationshil that adds together intermediate Import requirements (theproduct of the import coefficient matrix, the Inverse matrix, and finaldemand) and final demand Import requirements (the product of the finaldemand import coefficients and final demand). In the present application.however. an additional "updating" parameter q is inserted, to take accountof the fact that the coefficlent matrices (M. V. F) which are derived from1963 data will not accurately reflect 1986 coefficlents. The parameter qis essentially a "fudge" factor that callbrates the model to actuallyobserved results in its base configuration.

(M1) *i q1 tEJk Mu, * Vjk ' (El Fk,l * yl,1986 * Ed ek.d 1986)

(E MFk1 * Y1 , 1 9 8 6)where q - updating factor

*- predicted importsM * intermediate import coefficlents of 1983 .input-output systemMP - final denand import coefficlents of 1983 systemV - domestic inverse coefficient matrix of 1983 lnput-output systemF - final demand coefficients of 1983 input-output systemy - level of final demand (consumptlon, Investment)e a observed exportsi.j,k a input-output sector index1 - final demand sector indexd - export destination index (-U.S. Japan. Rest of World)

The sector-specific updating factors q are defined as the ratios of actuallyobserved imports in 1986 to the imports that would have been predicted bythe 1983 coefficients and 1986 final demands:

(82) q- ma1986 / [EJk Mi, .j.k (El Fkl * Y1.1986 £d ek,d,1986)(El MFkl Y1.1986)]

where a - actual imports

Given the construction of q, equation BI yields actual 1986 imports with1986 final demands and the base (i.e. 1983) coefficient matrices.

Projected imports were decomposed Into U.S.. Japanese. and Rest ofWorld imports using share coefficients:

(93) * l US a Sa .Us pM*

where Sl.US i,US,9 / 19 iUS 1986 ai,J 1986 mi.R1986)

- share of.U.S. imports In total imports, by sector

Slilar specifications are used to predict a' for J (Japan) and R (Rest ofWorld). Again, with 1986 final demands and base coefficients, this formulaylelds actual 1986 import levels from each trade partner.-

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Exchance Rate Changes

Exchange rate scenarios can be constructed by specifying the cost offoreign exchange In terms of won. which In turn affects the prices offoreign goods in terms of won. For example, the scenarios of won and yenappreciation, respectlvely, can be expressed as the following price changes:

a. 10% won appreciatlon: PijU0.9, p1,J-0.9, Pi.Ra 9 for all J.

b. 10% yen appreclatlon: P J PIAR 1 0 - for all 1.

These price changes will affect:

a. Exports to each of the three trade partners.

b. Import coefficients (M and MF) that determine overall iuports Inintermedlate and final demand.

c. Share coefficients (S) that determine how imports are dlvided amongthe three trade partners.

In specifying the magnltude of the resulting trade coefficient changes, itIs necessary to make a number of assumptions about "pass-through," that is.the effect of foreign price changes on donestic prices. It is assumed herethat:

a. U.S.. Japan, and Rest of World overall demand and prlces are notaffected by Korean exchange rate changes (for example, changes ln thewon/yen exchange rate are fully passed through to Korean buyers ofJapanese products).

b. Korea is a price taker on foreign markets, i.e. its export and importprices are equal to foreign prices.

c. Prices of domestically-produced goods are given by a constant markupover cost -- i.e. domestic and imported products are not perfectsubstitutes. Changes in Import prices due to exchange rate changestherefore affect the prices of Korean products only to the extent thatthey directly or indirectly depend on imports.

The last assumption helps us to abstract from general price level changes thatmight be triggered by an exchange rate adjustment. For example, econometricstudies show that half or more of a nominal depreciation Is typicallyeroded by Inflation. Thus, in the present case, we shall be examining realexchange rate changes only, that is, depreciation or appreciation in excessof changes in the domestic price level (i.e. value added deflator).

The volume effects of these exchange rate and price changes were simulateduslng a "substitution" model, which took into account the competitivenessof alternative sources of supply. In its general form. the substitution modelassumes that a given demand (be it the demand for imported cars In theU.S.. or Imported cotton in Korea) can be filled from several differentsuppllers, whose products are isperfect substltutes. Buyer's preferencesare assumed to be given by CES functions, Thus, the share of each supplier

- 117 -

depends on the price of its product relative to a market price "index." acomposite price based on the prices of all competing suppliers. SupplierI's share is:

(84) VI . * (p / pj)b

where P ( vt pb-I I1/b-

where v a supplier's sales/total demandv° - supplier's base sales/total demand. i.e. when all pi i l.p * supplier's priceP - composite price index of demand bundleb - substitution elasticityI - index of supplier: Korea, U.S.. Japan, Rest of World

This substitution model was used to determine volume changes In each of thethree areas outlined above. In each case, the competitors were assumed tobe Korea and Its three trade partners -- the U.S., Japan, and the Rest ofWorld. Foreign prices were determined by the exchange rate scenario, whileaKorean prices were calculated using the input-output dual, under theassumption that imported input price increases are passed through, but nochange occurs in the price of Korean value added.

Price Elasticlties.

The lnput-output model, coupled with substitution models to determinetrade, offers a richly-detailed framework for exploring the effects ofbroad changes in trade prices, such as exchange rate changes, or selectivetaxes designed, say, to switch imports from one trade partner to another.The operatlon of model, however, is sensitive to the choice of substitutionelasticities. Detailed empirical estimates of substitution elasticitiesare not available, and therefore plausible values based on work In othercountries had to be used. The central values chosen are shown in Table 1;they are comparable to values estimated az,d used In studies such as Petri(1984) and Whalley (1985).

Table 1. Substitution Elasticity Assumptions

Model Component Elasticity of Substitution

Shares of Imports All Raw Materials Sectors: 0.5in Demand All Intermediate Goods Sectors: 2.5

All Capital Goods Sectors: 1.5

Shares of Partners 1.5 times the overallin Imports elasticities

Shares of Partners To U.S.: same as overall elasticie.sIn Exports To Japan: 0.5 times overall

To Rest of World: 0.75 times overall

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The price elasticity of trade. or the ultimate expenditure-shiftingeffect of the substitution elasticities, depends on various factors, lncludingthe distrlbutlon of trade over different product categories. It alsodepends on whether trade consists of products for which nearly all demandis supplied by on one competitor -- for example, consists of products whichall cone from Japan or the U.S.. but not usually both. A price change ln acategory dominated by a single supplier will not have a large expenditure-shifting effect even if the substitution elasticity is large. In suchcases, large substitution elasticities can be associated wlth low priceelasticities. Thus the "average" elasticity can only be determined bysimulating the effects of an exchange rate change. This is done In Table82. where the present average elasticities are compared to various empiricalestimates of the long-run price elasticity of Korean trade.

Table 2. Simulated Price Elasticities

Trade Flow/Study Exports Imports

Overall Trade

This study -1.4 -0.2Nam -1.1 -0.3Wang -1. -0.7Kwack -1.7 -0.5Otani-Park na. -0.3Shin -1.4 -0.7Shin et al. -1.4 n.a.Kim -1.4 -0.2

Trade with U.S.

This study -1.6 -0.3Kwack -2.5 -0.7

Trade with Japan

This study -1.0 -0.0Kwack -0.6 -0.0

Notes: Nam. Wang. Otani-Park, Shin. Shin et al., and Kimestimates are from Yoonbal Kl. "Import and Export Functionsin Korea." International Monetary Fund. December 17. 1984.Kwack estimates from Sung Y. Kwack. "Exchange Rate Effectson Korea's Economy," World Bank. September 8. 1987,

- 119 -

As Table 2 shows, on an aggregate level the present elasticity resultstall well wlthin the range of empirically-derived estimates. This testcannot be applied. unfortunately, to the model s partner-specific results.since such estimates are not available, excepting Iwack's very rough guesses.In general. comparisons among elasticitles should be treated with caution.Different estlates use different price and Income variables; they sometimesrefer to nominal and sometimes to real changes in the exchange rate; andor they could be short- or long-run estimates. For example, the rule of thumbfrequently used in Korean pollcy circles, that a 10% appreciation willreduce the trade balance by S2 billion. is probably a short-run estimate.of a noalnal appreciation. The long-term effect of a similar real appreciationis likely to be 54-5 billion. Finally, since it Is evident that importsare very sensitive to exports, it makes a great deal of difference whetherthe estimate of the import price elasticity controls for export changescaused by exchange rate changes (ideally, exports should appear separatelyin the regression equation) or simply lumps the export effects Into the priceeffect.

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Korea Managing an External Surplus: Monetary and Trade...

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