Large capital inflows to Korea: the traditional developing economy story?

Large capital inflows to Korea: the traditionaldeveloping economy story?

Larry H. Filer II

Department of Economics, Old Dominion University, Norfolk, VA 23529, USA

Received 1 September 2003; received in revised form 1 October 2003; accepted 1 November 2003

Abstract

It is well documented that global shocks have been the main cause of capital flows to developing

countries. This paper uses a structural model of a developing economy to examine the causes and

consequences of large capital inflows to South Korea during the 1990s to see if their experience with

large inflows matches the usual developing economy story. The results indicate that inflows to Korea

were largely a result of global shocks. However, unlike the experiences of Mexico and Latin

American economies, Korean real money shocks are more important than global shocks at short-

horizons and nearly as important at long-horizons. In addition, the large inflows produced con-

sequences largely detrimental to the future state of the Korean economy. It is concluded that the

Korean experience was not entirely identical to the experience of a typical small open economy.

# 2003 Elsevier Inc. All rights reserved.

JEL classification: F30; F32

Keywords: Capital inflows; Korea; Small open economy

1. Introduction

Developing countries accumulated enormous amounts of foreign debt during the 1990s.

The resurgence began with Mexico in 1990 and then continued with developing Asia in the

latter part of the decade. These inflows provided needed capital to credit-constrained,

developing economies that allowed faster economic growth than the autarky outcome.

However, following the large inflows to Mexico, the economy experienced a severe crisis.

In fact, the analysis of the Mexican experience provided overwhelming evidence that large

inflows to developing economies are not entirely beneficial (Calvo, Leiderman, &

Journal of Asian Economics 15 (2004) 99–110

E-mail address: [email protected] (L.H. Filer II).

1049-0078/$ – see front matter # 2003 Elsevier Inc. All rights reserved.

doi:10.1016/j.asieco.2003.11.002

Reinhart, 1993). Nonetheless, just years later, Korea was accumulating large amounts of

private capital (Fig. 1). However, the Korean case was heralded as being a ‘‘miracle’’ in the

global economy, even after the events in Mexico and Latin America.

Why was the Korean experience with inflows perceived as different than the experiences

of other developing economies? One difference between the Korean episode and the Latin

American episode was the composition of the flow itself. The large inflows to Korea

consisted primarily of large amounts of debt offered by the banking industry and foreign

direct investment (FDI), (Dooley, Fernandez-Arias, & Shin, 1997). In Mexico the inflows

were dominated by large amounts of portfolio investment. Portfolio flows are often

considered to be short term, highly speculative and unstable. Alternatively, FDI flows

are thought to be long-term commitments that are not prone to rapid reversal. As a result,

economists often suggest that FDI and other official flows are less volatile and more

beneficial to developing economies than portfolio flows (Turner, 1991).

Clearly the composition of Korean capital inflows provided little information as to their

ultimate consequences. However, this should not come as a surprise. On the heels of the

Mexican crisis, work by Claessens, Dooley, and Warner (1995) illustrated that regardless of

type, capital inflows can be prone to reversal.1 As an alternative, inflows to developing

1990 1991 1992 1993 1994 1995 1996 1997-15000

-10000

-5000

0

5000

10000

15000

20000

25000Capital Flows

Fig. 1. Net capital flows in Korea.

1 This result is important for two reasons. First, it means that even the inflows to Korea were potentially

unstable. Second, it makes the measurement of capital flows easier since the measure can include both FDI and

portfolio flows. Therefore, it can be measured by the balance of payments identity.

100 L.H. Filer II / Journal of Asian Economics 15 (2004) 99–110

countries can be categorized by their proximate causes. Inflows, irrespective of type,

can result from either improving domestic conditions, or deteriorating foreign conditions,

or a combination of the two. In general, flows that result from deteriorating foreign

factors should be less stable than those inflows induced by improving domestic con-

ditions. Therefore, we can think of an alternative classification system which labels flows

caused by domestic factors as ‘‘pull-capital,’’ and those resulting from foreign factors as

‘‘push-capital.’’2

Previous empirical work has illustrated that domestic conditions were not the primary

cause of the inflows to Mexico and other emerging Latin American markets in the early

1990s (Calvo et al., 1993; Fernandez-Arias, 1996). Instead, inflows to this region were a

result of deteriorating US factors. Some of these factors included, decreasing US interest

rates, an ongoing US recession and excess financial capital in the United States.

Though the literature often examines the causes of large inflows, the consequences on

the capital receiving country are typically ignored. However, Calvo et al. (1993) were

among the first to empirically illustrate that capital inflows are often accompanied by real

exchange rate appreciation within the domestic country. If the foreign inflow is unsterilized

by the central bank, then the capital inflow will be matched by an increase in domestic

absorption. Further, if this increase in spending is directed at nontraded goods, then their

price increases against that of traded goods and the real exchange rate subsequently

appreciates.

In addition to real appreciation, standard open-economy models predict that inflows

could result in rapid monetary expansion accompanied by enormous inflationary pressure.

As pointed out in Lopez-Mejia (1999), the monetary consequences vary and depend on the

exchange rate regime in place. The managed rate regime forces the periodic intervention of

the central bank to sterilize the inflow. This defense of the parity leads to international

reserve accumulation and a subsequent increase in the money supply. However, under a

float the nominal exchange rate appreciates, alleviating the pressure on the price level, but

creating a real appreciation over time.

Finally, capital inflows should result in increased real output. The benefit of foreign

capital is that it alleviates the need for high domestic savings rates. Idiosyncratic

borrowers are able to obtain funds and maintain or expand operations. Small output

affects, following large inflows, can be a sign of poor capital management by the domestic

economy, or imperfect credit markets within the economy. Both are highly likely in

developing economies.

This paper examines both the causes and consequences of the recent inflow episode to

Korea. Within the framework of a structural vector-autoregression model (SVAR), I

analyze the causes of capital inflows, via decomposition of variance, and the domestic

consequences of capital inflows, via impulse response functions. This analysis will help

determine whether the Korean episode followed the traditional developing economy

sequence of events or was, in fact, atypical.

The remainder of the paper is organized as follows. Section 2 develops a small open-

economy model of capital flows suitable for the sample countries. Section 3 examines the

2 These labels have been used recently in Fernandez-Arias (1996).

L.H. Filer II / Journal of Asian Economics 15 (2004) 99–110 101

dynamic relationships within the structural model. Finally, Section 4 provides concluding

remarks.

2. A model of capital flows in a small open economy

Small open economies are subject to both domestic and global shocks. In particular,

previous work has examined the contribution of both domestic and foreign factors in

explaining capital flows to developing nations. Calvo et al. (1993), Kim (1998), and

Fernandez-Arias (1996) are among the many which model capital flows as a function of

shocks to both foreign and domestic variables. These works along with Chuhan, Claessens

and Mamingi (1998), emphasize the importance of US interest rates in explaining capital

flows to Latin American countries. In addition to foreign interest rate shocks, global supply

shocks and shocks to the world terms of trade have also been examined. The impact of

global supply shocks is, intuitively, ambiguous. The typical story is that recessions in

foreign countries could create decreased return on investments in those countries. This

should act as a catalyst for capital substitution from developed markets to developing

markets. However, booming foreign markets could also lead to excess liquidity and the

dumping of capital in markets previously ignored.

Domestic fiscal and monetary variables are important as a signal of future stability in

the economy. Deflation was a well-documented characteristic of the Mexican inflow

experience. Also, on the domestic side, previous models have included shocks to: the

domestic rate of return, domestic supply, the domestic investment climate, and country-

creditworthiness.

In this section, I develop an empirical model of capital flows for a developing economy.

Using previous work as a foundation, I consider two foreign shocks and four domestic

shocks.3 Among the foreign shocks are global supply shocks and shocks to global rates of

return. The literature has correctly identified the US as the main foreign influence on capital

flows to Latin America. However, when dealing with Korea, Japan seems equally, if not

more, important as a foreign influence. Japan has consistently contributed large amounts of

FDI and portfolio capital to the Asian region. Therefore, in contrast to previous work,

foreign interest rates and foreign output are generated as an equally weighted index of US

and Japanese variables.4

Among the domestic shocks, I consider are domestic supply shocks, monetary shocks

and shocks to the real exchange rate. Domestic productivity shocks are an obvious choice

for inclusion. Business cycle expansions signal increased profit opportunities and thus

should lead to capital inflows. Likewise, as mentioned above, monetary shocks are often an

important indicator of future inflationary policy. Expected, future stability in prices could

stimulate current period inflows. Finally, the relationship between capital flows and real

3 For a detailed description of each variable in the model, please refer to the data appendix at the end of the

paper.4 Weighting schemes which placed more emphasis on Japan were experimented with, but produced very

similar results. Without any clear reason for applying different weights to the foreign countries, the variable will

be generated as an equally weighted index.


exchange rate movements is well documented (Agenor, 1998; Agenor & Hoffmaister,

1996; Calvo et al., 1993). Thus, real exchange rate shocks seem essential.

One rather contentious omission from the model is a measure of the domestic rate of

return. In defense of this omission, I offer the following. It is well known that smaller

economies possess poorly developed financial markets. Also, through policies such as

credit rationing, the local government can manipulate financial markets. Therefore, it is

not clear that either the domestic interest rate or the interest differential between domestic

and foreign assets provides any information as to the true return on the domestic

investment.

The above discussion suggests that the capital account can be modeled in general as

follows:

kat ¼ f ðuy�

t ; ui�

t ; uyt ; uq

t ; urmt ; uka

t Þ (1)

Eq. (1) models the capital account is as a function of structural shocks to: (1) the foreign

output index, uy� , (2) the foreign interest rate index, ui� , (3) domestic output, uy, (4) the real

exchange rate, uq, (5) domestic real money, urm, and (6) random shocks to the capital

account itself, uka.

The true structural shocks in Eq. (1) are unobservable. What we observe within the data

are combinations of the structural shocks. Therefore, to recover the ui’s from the observed

shocks (reduced-form shocks) we make the following identifying restrictions:

1. Foreign variables are affected by the foreign shocks only.

2. Domestic output is not influenced by shocks to real exchange rates, real money growth

and capital account changes contemporaneously.

3. The real exchange rate is affected by shocks to real money growth and the capital

account at a lag and by shocks to output and own shocks contemporaneously.

4. Real money growth is affected by shocks to the capital account at a lag and affected

contemporaneously by the structural shocks of other variables.

5. The capital account responds contemporaneously to all structural shocks to the system.

Keeping in mind the above restrictions, consider the following model in general form:

Yt ¼ A0Yt þ A1Yt�1 þ � � � þ AkYt�k þ Ut (2)

where, for our purposes, Yt ¼ ðy�; i�; y; q; rm; kaÞ0, Ut ¼ ðuy�

t ; ui�

t ; uyt ; u

qt ; urm

t ; ukat Þ0, the

asterisk (�) represents an external variable and the Ai are the structural responses of

the endogenous variables to the mutually orthogonal structural shocks Ut.

The model contains two external shocks. The foreign output variable and the foreign

interest variable are assumed exogenous to the developing country. Accordingly, the two

external shocks as well as the four domestic shocks affect domestic variables. These

conditions imply that the general model can be written more specifically as:

y�t ¼ d1 þXn

k¼1

b11k y�t�k þ

Xn

k¼0

b12k i�t�k þ e1

t (3a)

i�t ¼ d2 þXn

k¼0

b21k y�t�k þ

Xn

k¼1

b22k i�t�k þ e2

t (3b)


Xt ¼ dþXn

k¼0

CkXt�k þXn

k¼0

DkZt�k þ E (3c)

where Xt ¼ ðyt; qt; rmt; katÞ0, Zt ¼ ðy�t ; i�t Þ0, Ck and Dk are coefficient matrices and E is the

matrix of reduced-form innovations, eit, for the domestic variables.

(3a) through (3c) is pseudo-structural in the sense that long-run exogeneity is imposed

on the equations for the external factors (3a) and (3b). In addition, to recover the structural

residuals within (3c), the identifying restrictions above imply the recursive ordering of the

variables within X that is given above. Therefore, identification of the contemporaneous

matrix, C0, is done by Cholesky decomposition.5

3. Empirical results

3.1. Causes of capital flows

The system (3a)–(3c) is estimated with a constant and a seasonal component to capture

the seasonality in the money series (Fig. 2). Furthermore, the foreign equations, (3a) and

1990 1991 1992 1993 1994 1995 1996 19976.3

6.4

6.5

6.6

6.7

6.8

6.9

7.0

7.1

7.2Real Money

Fig. 2. The log of real money.

5 As a check, several of the more common identifying restrictions in macro VAR’s was imposed and tested.

The results of the likelihood ratio tests suggested that these restrictions were inappropriate.


(3b), are estimated with four lags, while the domestic sub-system is estimated with seven

lags of each variable.6 The estimation period spans the inflow episodes from 1984:1

through 1996:12. Liberalization policies of the 1980s and 1990s make Korea structurally

different than any other time (maybe with the exception of the global environment in the

early 1900s) in its history. Therefore, restricting myself to this sample period will help to

reduce the influence of structural breaks.

Table 1 provides a look at the variance decompositions for capital flows. The impact of

the foreign factors on the domestic variables is quite large. By adding columns two and

three, we can see that innovations to the foreign output and foreign interest rate index

account for about 21% of the variance in capital flows at 6 months. That number steadily

increases up to 27% at the 24-month horizon. Alternatively, domestic variables are less

important. Focusing on the 24-month horizon, shocks to domestic output account for only

4%, while real exchange rate shocks also only account for 4%. These results are consistent

with previous developing country findings.

However, shocks to the real money variable provide more information than global

shocks at short-horizons (15.5% at 6 months) and only slightly less than global supply

Table 1

Decomposition of the forecast error variance for the capital flow series

Month y� i� y q rm ka

1 2.10454 0.63535 0.00000 3.18868 9.08081 84.99062

2 1.94419 4.12847 0.87528 4.13717 9.31098 79.60390

3 9.53575 6.16016 1.70229 3.48549 15.08250 64.03382

4 9.37230 6.22160 1.77276 3.70324 16.03980 62.89030

5 11.44136 7.10636 1.83345 3.66610 15.07074 60.88199

6 14.32756 6.94395 3.49832 3.39763 15.49306 56.33947

7 13.68129 6.91182 3.32550 3.27855 15.48491 57.31793

8 15.17833 6.75959 3.57933 3.21171 14.91386 56.35717

9 15.17311 8.01676 3.69507 3.14625 14.99229 54.97653

10 15.08894 7.95816 3.68880 3.13045 15.50860 54.62505

11 16.82505 7.98433 3.81384 3.02249 14.97324 53.38105

12 16.81979 7.92116 4.33841 3.03991 14.98820 52.89252

13 16.73771 7.91836 4.31569 3.07864 15.22492 52.72468

14 17.13138 8.05118 4.36349 3.09561 14.97007 52.38828

15 17.12003 8.05546 4.41195 3.18510 14.97112 52.25634

16 17.11630 8.38434 4.38167 3.25280 15.00836 51.85653

17 17.31243 8.83105 4.39223 3.28112 14.78306 51.40011

18 17.25017 8.98528 4.46727 3.39412 14.74880 51.15435

19 17.22453 9.21937 4.44233 3.49437 14.75163 50.86776

20 17.24011 9.49075 4.41028 3.57039 14.60800 50.68046

21 17.20201 9.61703 4.39606 3.69010 14.56327 50.53152

22 17.15841 9.89796 4.38081 3.78965 14.52212 50.25105

23 17.13741 10.17588 4.34518 3.87565 14.40944 50.05645

24 17.08495 10.32253 4.32973 3.99831 14.36049 49.90399

Note. Each column represents the percent of the variation in capital flows explained by structural innovations to

the variable listed at the column head. Decompositions are provided from the 1-month to the 24-month horizon.

6 Lag length was suggested by the multivariate version of the Schwartz Bayesian criteria.


shocks at long-horizons (14.3% at 24 months). This is quite unlike the previous work on

Latin America, which found that country-specific shocks did little to explain a significant

portion of the variation in capital flows. This result is consistent with the findings in Chuhan,

Claessens, and Mamingi (1998) which found that global shocks dominated capital flows in

the Latin American episode, but in Asia country-specific shocks were at least as important.

The relaxation of exchange rate and interest rate pegs in Korea during the 1990s has exposed

the economy to foreign shocks much more than other Pacific Rim countries, yet the

relatively mature financial system has also insulated the economy from these same shocks.

3.2. Consequences of large capital inflows

The impulse response functions for Korea are illustrated in Figs. 3–5. Like many of the

Southeast Asian economies, Korea was following a managed exchange rate policy. As

discussed earlier, defense of the exchange rate peg should result in monetary growth. Fig. 3

depicts a large spike in real money immediately following the inflow and continued

monetary expansion out 5 months. Real money than levels off and actually begins to

0 2 4 6 8 10 12 14 16 18 20 22-0.25

0.00

0.25

0.50

0.75

1.00

1.25Real Money

Capital Flows

Fig. 3. Response of real money to a one standard deviation increase in capital inflows. Note: Here and in Figs. 1

and 2, the impulse response functions have been standardized so as to avoid the problems associated when using

variables of differing units of measurement.


contract back towards the pre-shock level. The graph provides evidence that Korea did

attempt to sterilize capital inflows.

In the introduction it was suggested that real output effects following an inflow would

differ depending on the economy’s management of the extra capital. Fig. 4 depicts very

little increase in Korean real output following the inflow. Prior to Korea’s crisis this result

would be hard to defend. However, in the aftermath of the crisis, details surfaced regarding

bribery in the credit allocation process, along with credit—rationing to support export-led

growth. Therefore, a repressed financial environment effectively eliminates the potential

increase in real output.

Finally, the pegged rate policy of many Southeast Asian countries (including Korea)

prevented large real appreciations following the inflow episode (Lopez-Mejia, 1999).

Under this policy, the real rate can remain stable or even initially depreciate. The money

supply would bear the burden of adjustment in this case. To illustrate this, the real exchange

rate effects for Korea are depicted in Fig. 5. The real rate follows expectations with respect

to developing economies. As a result of the managed nominal rate, the real rate initially

depreciates and continues this path through 7 months. After the current exchange rate

policy is aborted (either through devaluation or abandonment of the system altogether), the

real rate follows a path of appreciation through 24 months and beyond. Therefore, as

expected, the inflow episode creates a lagged, but persistent appreciation.

0 2 4 6 8 10 12 14 16 18 20 22-0.25

0.00

0.25

0.50

0.75

1.00

1.25Real Output

Capital Flows

Fig. 4. Response of real output to a one standard deviation increase in capital inflows.


4. Conclusions

This paper applies a structural model of capital flows to Korea in an attempt to analyze

the dynamics surrounding the inflows in the 1990s. The model, which consisted of two

external shocks and four domestic shocks, was consistent with underlying theoretical

expectations about small open economies. The empirical model allows me to analyze the

relative importance of foreign and domestic shocks to capital flows, while also illustrating

the consequences of large capital inflows on the real exchange rate, the real money supply

and real output.

The results illustrate an inflow episode with dynamics much the same as those associated

with other recent large inflows to developing countries. Consistent with the previous

literature, the main cause of the flows in and out of the Korean economy was external

factors. I find a significant role for external factors in determining the future path of capital

flows. Therefore, like previous work on the Latin American experience with large inflows,

innovations to the foreign output series are important in explaining the capital flow series

for Korea. However, unlike studies on Latin American economies, the Korean real money

supply also plays a significant role. In fact, at short-horizons, innovations to real money are

more important in explaining capital flows than the global shocks and nearly as important

at longer horizons. This suggests that the Korean inflow episode cannot be simply labeled

as an experience with unstable ‘‘push-capital.’’

0 2 4 6 8 10 12 14 16 18 20 22-0.36

-0.18

0.00

0.18

0.36

0.54

0.72

0.90

1.08Real Exchange Rate

Capital Flows

Fig. 5. Response of real exchange rate to a one standard deviation increase in capital inflows. Note: A decrease

in the real exchange rate index represents real appreciation of the Korean won.


The paper also examines the consequences of a capital inflow. The three consequences of

increases in net inflows to Korea seem to follow the traditional developing economy story.

First, Korea experienced an immediate increase in real money supply probably due to

defense of the nominal exchange rate. Second, there is evidence of real appreciation of the

won in the long run as spending on domestic nontradables increases over time. Finally, it

appears that much of the potential real domestic output increases are negated due to

inefficiencies in domestic credit markets.

Acknowledgements

I wish to thank Yoonbai Kim, Jim Fackler, Muhktar Ali, Chris Waller, and David

Selover for valuable discussions. I am also grateful to two anonymous referees and the

editor for comments which improved the paper substantially. Any errors which remain are

my own.

Appendix A

All series are monthly and were obtained from the International Financial Statistics

March 99 CD-ROM. The foreign variables, y� and i� are generated as equally weighted

linear combinations of the appropriate US and Japanese variables. Industrial production is

used for the foreign output series and the T-bill rate (Government Bond rate) is used for the

US (Japan) interest rate. In addition, an equally weighted price index was generated to be

utilized whenever foreign price levels are necessary.

Korean output is represented by the industrial production index. The real exchange rate

(RER) is generated as the deviations from Purchasing Power Parity. Also, since the

weighted CPI index is used as the foreign price index, the RER can be considered an

effective real exchange rate index. Real Money is defined as M2, which is approximated by

the sum of M1 and quasi-money, then deflated by the Korean CPI.

Finally, the capital account is generated from the balance of payments identity as the

change in official reserves subtracted from the current account and then multiplied by the

exchange rate to convert the series to won. When working with capital flows, it is often the

case that it is incorporated as a ratio to GDP. That approach is not used here. The variable ka

represents the raw capital flow at time t.

All variables are in logs with the exception of the capital account.

References

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Large capital inflows to Korea: the traditional developing economy story?