Choong-soo Kim, James Joo-Jin Kim Visiting Professor of Korean Studies, University of Pennsylvania; former Governor, Bank of Korea.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Governor Kim: The answer is yes, indeed. I say this from the perspective of a former Governor of the Bank of Korea. Until late 2011, the Bank had a single mandate: to maintain price stability. Following the global financial crisis, the National Assembly of the Republic of Korea revised the Bank of Korea Act by stipulating that, as the central bank works to secure the objective of price stability, due consideration must be paid to maintaining financial stability. The financial stability mandate is not in parallel with the price stability mandate. Instead, it is to be considered as a factor in decision making about price stability. Nevertheless, based upon the revision of the Act, today the Bank of Korea has to give high policy priority to macro-prudential policy for financial stability.
Although the central bank does not have specific micro-prudential regulatory tools, it plays a significant role in bringing attention to potential sources of financial instability by submitting the bi-annual Financial Stability Report to the National Assembly. This report contains not only the monitoring and analysis of the banking sector, but also of non-banking financial institutions.
Secondly, there was a substantial change in the perception of credit easing policies. For some years, Korea has used a bank-intermediated lending support facility for small- and medium-sized enterprises (SMEs). But the facility had been used with caution and less actively. Under the single mandate of achieving price stability, such a credit easing policy was not considered appropriate as a primary tool for monetary policy. For a country like Korea, which does not have an international reserve currency, quantitative easing (QE) policies were not considered effective. Therefore the central bank began using the SME lending facility. While such a policy tool may help in enhancing the productivity of small- and medium-sized enterprises, it was also thought to contribute to maintaining financial stability by reviving the young SMEs with technological potential that had short-term financial difficulty. Although the policy was initiated as a qualitative easing policy rather than a quantitative easing policy, it did eventually contribute to increasing liquidity quantitatively.
Another point I would like to mention is that the Bank of Korea began actively pursuing bilateral currency swaps with other central banks. Like some other emerging economies, Korea benefited greatly from the bilateral currency swaps with the Federal Reserve in stabilizing financial markets at the beginning of the global financial crisis.
Related to this, at the 2010 G20 summit hosted in Seoul, Korea has proposed the establishment of a global financial safety net to protect innocent bystanders from global financial crises. The global financial safety net has several layers: bilateral currency swaps, regional financial arrangements, and facilities at the global level like the IMF’s Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL). Of course, bilateral currency swaps in international reserve currencies, including U.S. dollars, will be the most effective. But local currency swaps can also be helpful. As a matter of fact, local currencies are now used for trade settlement between Korea and China. And, the Bank of Korea and the People’s Bank of China agreed to play roles in clearing those transactions, using bilateral local currency swap arrangements between the two central banks.
Where should we be looking now for financial stability risks?
Governor Kim: I have a few thoughts on this. Needless to say, the abundance of global liquidity due to the QE policies of the advanced economies is the most imminent of source of global financial risk. It is not yet clear how such a large amount of global liquidity will be absorbed in the real economy. We do not know how the deterioration of central bank balance sheets will affect the independence of monetary policy and of central bank operations. Furthermore, avoiding bubbles in asset markets is crucial for maintaining global financial stability. The problem is that, while we live in a global economy, we lack an actor with global jurisdiction. In this regard, I welcome the strengthening of efforts by international financial institutions such as the IMF and BIS to deal with excessive global liquidity issues.
Secondly, a major source of financial instability comes from the low productivity of SME's. Restructuring of zombie SME's will emerge as a critical policy challenge for many emerging market economies going forward. During the global financial crisis, few efforts were made to restructure low productivity small- and medium-sized enterprises. In the case of Korea, the credit guarantee system for SMEs has been operated somewhat leniently, resulting in moral hazard and an inefficient use of financial resources.
The third risk is the interest rate normalization of the Fed. Although it is inevitable that the Fed will begin interest rate normalization in the near future, such a move will necessarily bring about another “taper tantrum.” For Korea, this raises two concerns. The first is the financial instability due to the increase of debt servicing by heavily indebted households, particularly for low income households. Although the 2011 Cecchetti, Mohanty and Zampolli paper did not provide a statistically significant empirical relationship between household debt and economic growth, I think the excessive household debt will become a source of financial instability. Unlike advanced crisis economies, household deleveraging did not take place in Korea. This is why I am so concerned about the ever-increasing household debt in Korea.
My second concern related to interest rate normalization is that it will create volatility in foreign exchange markets. This is particularly relevant for a country like Korea, which is quite vulnerable to external shocks. When the Fed increases the policy rate, unless the Bank of Korea raises its policy rate correspondingly, there is a high likelihood that foreign capital will exit the Korean market. As a consequence, volatility will rise and the foreign exchange market will become unstable. This is indeed a compelling reason why a strengthened effort should be made to establish a global financial safety net. Macro-prudential regulations, such as setting ceilings on derivatives positions and imposing financial stability levies on non-core bank liabilities, have been introduced to deal with such high volatility for the case of Korea. But it is naive to assume that such macro-prudential regulations are sufficient to prevent excessive volatility.
Finally, I would like to point out that policymaking is also likely to become a source of financial risk in the future. As foreign exchange rates overshoot and markets over respond, policy makers tend to overreact. This results in making too frequent Type II errors; namely, sending false warning signals. The cost of making Type I error – missing the call of the financial crisis – can be so devastating that policymakers now tend to make Type II errors more easily and frequently. In these cases, the costs are not realized immediately. The policymakers’ actions, however, may have effects that further aggravate the situation. With the benefit of hindsight, I am afraid to say that policymakers may have overestimated the negative GDP gaps by not paying due attention to the possibility of a decline in potential growth rates after the global financial crisis. If this is the case, then the policy measures that have been undertaken would have been excessive.
What do we need to do to preserve the benefits of global finance?
Governor Kim: I would like to highlight three issues. First, from a macroeconomic perspective, emerging market economies should have made more effort to promote financial deepening and financial integration. Without these, they cannot take full advantage of global finance. Institutions in emerging market economies have to be reformed to be in line with global norms. As globalization is inevitable for every economy, the sooner efforts are made to open up markets and liberalize regulations, the better.
Second, from an international economic perspective, more effort should be made to find a compromise to resolve the conflicts between the advanced and emerging economies. For example, a more stringent Basel III mandate would require that banks hold more long-term capital and liquidity. But this is in conflict with an increasing need for long-term infrastructure finance in emerging market economies. Avoiding regulatory arbitrage is important from the view of the advanced economies in order to avoid another crisis. But, promoting growth of emerging market economies is equally important for global economic prosperity.
Thirdly, I believe it is urgent to restore trust in finance. Trust in the financial market has been undermined by the greediness of financial institutions and by their incapacity to handle very complex financial products like derivatives. These issues are somewhat related to the need for a global jurisdiction. I think, on the one hand, that a comprehensive global financial regulatory system has to be established. On the other hand, more efforts have to be made to build capacity in academia and research organizations, so that our understanding of financial markets can be improved.