Republic of Korea: Selected Issues

International Monetary Fund. Asia and Pacific Dept

doi:10.5089/9781498314824.002.A001

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Republic of Korea: Selected Issues

Author: International Monetary Fund. Asia and Pacific Dept

Publication Date:: 13 May 2019

eISBN:: 9781498314824

ISBN:: 9781498314824

Language:: English

Keywords:: ISCR; CR; opt-out agreement; financial condition; transmission open; IMF staff calculation; monetary policy rate; interest margin; inflation cycle; Financial sector stability; Financial cycles; Asset prices; Central bank policy rate; real GDP

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Selected Issues

Abstract

Selected Issues

Evolution of Macroprudential Policies in Korea

1. The primary aim of macroprudential policy is to secure financial stability by leaning against excess financial conditions. FSB, IMF, and BIS (2011) define macroprudential policy as “a policy that uses primarily prudential tools to limit systemic or system-wide financial risk, thereby limiting the incidence of disruptions in the provision of key financial services that can have serious consequences for the real economy . . . “. Rather than managing inflation or the business cycle, as monetary policy aims to do, macroprudential policy tries to strengthen the financial system’s defenses in the face of economic and financial shocks.

2. This Selected Issues chapter looks at (i) monetary policy and financial cycles; (ii) the evolution of macroprudential policies in Korea; (iii) the efficacy in prudential policies in taming financial excess and building financial resilience and; (iv) the interaction between monetary policy and macroprudential policies.

A. Monetary Policy and Financial Cycles: A Coordination Challenge

3. The financial sector is inherently procyclical and can amplify the real cycle. This amplification occurs through price and quantity channels. Bank lending is procyclical because liabilities tend to increase by more than assets during a credit boom, thus raising leverage. Moreover, because financial conditions are positively correlated with overall economic activity, price-based market risk indicators also tend to be procyclical.

4. Risks to financial stability arising from excessive procyclicality highlights several coordination issues among policymakers. These key factors include: (i) real and financial cycles operate at different frequencies; (ii) supply-side developments that constrain monetary policy in an inflation targeting regime; and (iii) monetary policy is too blunt an instrument for dealing with asset price bubbles. Each of these issues are explored in further detail for Korea.

Real and Financial Cycles Operate at Different Frequencies in Korea

5. The duration and amplitude of the financial cycle are not the same as those of the real cycle, which in real-time could lead monetary policymakers astray (Borio 2012). Drehmann, Borio, and Tsatsaronis (2012) note that the financial cycle operates at a much lower frequency than the traditional business cycle, while Borio and Lowe (2002, 2004) show that widespread financial distress typically arises from the unwinding of financial imbalances that build while disguised by benign economic conditions characterized by stable and low inflation.

6. There is a weak relationship between the credit gap and inflation and real and financial cycles have tended to peak and trough at different dates in Korea. A simple scatter plot of the credit gap and inflation from 1990 to 2018 does not report a statistically significant relation. Achieving price stability is therefore no guarantee that financial excess can be avoided. Leverage and financial cycles have tended to be more persistent with a larger amplitude cycle than traditional business cycles. These findings for Korea are in line with those documented for other advanced and emerging market economies, which show real and credit cycle operate at different frequencies. A low degree of coherence between real and financial cycles potentially spells coordination difficulties for monetary policy if the framework targets multiple objectives.

7. Coordination difficulties for monetary policy could potentially result in looser monetary policy than would otherwise be warranted. Monetary policy may not be the optimal tool for leaning against financial cycles if it is expected to moderate business and inflation cycles at the same time. Multiple objectives may also overburden monetary policy, creating an expectation gap between what the central bank can achieve and what it can deliver.

Supply-Side Developments in Korea have Constrained Monetary Policy in an Inflation Targeting Regime

8. Since the introduction of inflation targeting in 1999 in Korea positive supply-side developments have put downward pressure on inflation. This has constrained the room for monetary policy tightening. As inflation has declined, monetary policy rates have fallen, which, in turn, has depressed neutral interest rates. At the heart of this interpretation are two features: first, the neutral rate is defined as the rate that would prevail if actual output equaled potential output. Second, inflation is the key signal that output is not at its potential, sustainable level. This view presumes monetary policy only passively tracks the neutral rate over the medium term. Thus, the observed decline in real interest rates is purely a function of forces beyond the central bank’s control.

9. Various estimates of the neutral rate for Korea show a decline in the neutral real interest rate since the Asian crisis.¹ The decline in the neutral rate mirrors global financial trends and reflects, in part, the success of the Bank of Korea in moderating and stabilizing inflation. Since credit booms have not, historically at least, been accompanied by higher inflation— reflecting positive supply-side developments and improved central bank credibility— monetary policy focused on price stability has not needed to tighten beyond the neutral rate to restrain a buildup in financial imbalances in Korea. Therefore, where low policy rates are consistent with low inflation, they may contribute to excessive credit growth and the buildup of asset bubbles and thereby sow the seeds of financial instability (Juselius and others 2016). These factors reinforce the need for prudential policies that mitigate the buildup of financial risk in a low-interest-rate environment.

Monetary Policy Too Blunt for Dealing With Financial Imbalances.

10. Monetary policy affects financial prices and quantities. The risk-taking predicts that variations in monetary policy affects the effective risk appetite of financial intermediaries and, thus, shifts the supply curve for credit. Monetary policy impacts the price of risk and banks’ interest margin, causing financial intermediaries to shift their supply of lending.

11. Leaning against perceived deviation of financial prices from macro fundamentals relies on the assumption that higher rates will shrink an emerging financial or asset price bubble. This proposition is tested by examining the link between monetary policy and equity prices. The link between stock prices and monetary policy is established via a risk-neutral general equilibrium environment, as in Galí 2014 and Galí and Gambetti (2015). The stock price (Q) is decomposed into fundamental (Q^f) and bubble (Q^b) components, Q = Q^f + Q^b. In a risk-free environment, the fundamental component is defined as the present discounted value of future dividends

\begin{matrix} q^{f} = c o n s t + Σ_{j = 0}^{\infty} Θ^{j} [(1 - Θ) E_{t} {d_{t + k}} - E_{t} {r_{t + k}}], & (\begin{matrix} 1 \end{matrix}) \end{matrix}

The response of an asset price to a change in monetary policy can be expressed as

\begin{matrix} \frac{\begin{matrix} {\partial q}_{t + k} \end{matrix}}{{\partial ϵ}_{t}^{m}} = (1 - γ_{t - 1}) \frac{{\partial q}_{t + k}^{f}}{{\partial ϵ}_{t}^{m}} + γ_{t - 1} \frac{{\partial q}_{t + k}^{b}}{{\partial ϵ}_{t}^{m}}, & (2) \end{matrix}

in which γ = Q^b/_Q measures the relative size of the bubble component in the overall asset price. In response to a monetary impulse, the fundamental stock price can be traced out using

\begin{matrix} \frac{{\partial q}_{t + k}^{f}}{{\partial ϵ}_{t}^{m}} = Σ_{j = 0}^{\infty} Θ^{j} (1 - Θ) \frac{{\partial d}_{t + k + j + 1}^{f}}{{\partial ϵ}_{t}^{m}} - \frac{{\partial r}_{t + k + j}}{{\partial ϵ}_{t}^{m}}, & (3) \end{matrix}

in which Θ = d/r < 1 and d_t is the gross dividend yield, and r_t is the riskless real rate. Under the conventional view that monetary policy can be used to prick asset price bubbles,

\begin{matrix} \frac{\begin{matrix} {\partial r}_{t + k + j} \end{matrix}}{{\partial ϵ}_{t}^{m}} < 0 a n d \frac{{\partial d}_{t + k + j + 1}^{f}}{{\partial ϵ}_{t}^{m}} \leq 0, & (\begin{matrix} 4 \end{matrix}) \end{matrix}

which implies that a tightening of monetary policy should cause a decline in the size of the bubble. Hence, the overall effect on the observed asset price should be unambiguously negative, independent of the relative size of the bubble. The response of the bubble component can be backed out via the gap between the empirical stock price and the fundamental stock price responses $(Q^{b} = \frac{{\partial q}_{t + k}^{f}}{{\partial ϵ}_{t}^{m}} - \frac{{\partial q}_{t + k}}{{\partial ϵ}_{t}^{m}})$ to a tightening in monetary policy.

12. The focus is on the dynamic response of stock prices to an exogenous hike in the policy interest rate. The theoretical predictions in (4) are empirically tested for Korea, using a simultaneous equations model containing real GDP, the GDP deflator, KOPIX dividends, the short-term interest rate, and the KOPIX stock index from 1990Q1 to 2018Q2.

13. Tighter monetary policy has not, historically at least, been associated with falling equity prices. The estimates show that the bubble component (Q^b) of asset prices does not fall in response to a rising policy interest rate. This effect is persistent and statistically significant, and consistent with the theory of rational bubbles.

14. The link between monetary policy and the financial quantities is also tenuous in Korea. In particular, does monetary policy tightening impact credit developments? This is examined by using two standard empirical models that are only differentiated in the way that they identify monetary policy shocks over the inflation targeting period (1999m1 – 2018m8). In model 1 the monetary policy shock is identified as in Christiano, Eichenbaum and Evans (1999) and in model 2 using the procedure in Rubio-Ramirez, Waggoner and Zha (2010).

15. A surprise (100 basis point) non-systemic monetary policy tightening leads to a decline in GDP and the price level. However, there is an expansion in commercial and shadow bank assets. This effect seems to be robust across both model specifications. To put these findings into a historical perspective, the effects of a systemic monetary policy tightening in simulated against the counterfactual or no tightening. This is achieved by injecting a series of monetary policy surprises to leave policy rates up to 150 basis points higher over the past 18 months (2017m1-2018m7), implying a substantially tighter monetary policy than was realized. It is reasonable to expect that the public would not have immediately and fully understood this policy change, thereby, negating the Lucas critique. While this policy would have been effective in curbing output growth, expansion of commercial and shadow bank balance sheets would have accelerated. The value of commercial bank and NBFC assets would have grown between 3-to-6 percent faster over the last 18 months.

16. Achieving the financial stability objective will require dedicated macroprudential policies, which can be better tailored to financial risks. The empirical evidence for Korea suggests that monetary policy alone has been less effective in taming financial and credit cycles during the inflation targeting period. Moderating real and financial cycles will require well-tailored macroprudential policies, which will also have fewer unintended consequences on other sectors of the economy and other policy objectives.

B. How Have Macroprudential Policies Evolved in Korea?

17. This section explores two key questions: how have macroprudential policies evolved in Korea and their implementation have helped tame financial excess.

Macroprudential Policies in Korea

18. The use of macroprudential policies in Korea have evolved in two ways. First, the macroprudential toolkit has been expanded. Second, macroprudential instruments have been used more aggressively over the financial cycle.

19. There has been a shift in the types of macroprudential tools used in Korea to safeguard financial stability. A database of macroprudential policies constructed by the IMF (2018) shows a move away from monetary macroprudential tools to broader borrower-based prudential instruments. There are several reasons for this shift. First, reserve requirements progressively lost their importance as a monetary policy tool following the Bank of Korea adopting interest rate policy and inflation targeting. Second, there has been a recognition that financial cycles, such as housing credit and house prices, have become longer, larger, and less synchronized with real and inflation cycles. In response, policymakers in Korea have increasingly resorted to prudential measures to moderate credit and asset price cycles. Third, there has been a shift toward explicit macroprudential objectives following the Asian financial crisis.

20. Since the Asian crisis Korea has used prudential policies more actively to address financial cycles more systematically. A macroprudential policy index is constructed of prudential policies that principally target financial swings. The change in the aggregate macroprudential index has in general moved in phase with fluctuations in credit growth. Periods of higher credit growth have often been associated with tighter prudential policies and vice versa. The below charts illustrate aggregate ‘macroprudential policy response curves’ pre-and post-Asian crisis. The charts illustrate the probability of a tightening in macroprudential policies to credit and housing cycles, estimated using a logit model. Two findings stand out. First, the probability of macroprudential policies being tightened in response to a widening in the credit gap or house price growth in the period following the following the Asian crisis is significantly higher. Second, the macroprudential policy response has been non-linear, particularly with regards the housing market.

C. Have Prudential Policies Been Effective in Taming Financial Cycles?

21. The effect of macroprudential policies on financial indicators is estimated using local projections. The projections are drawn from a robust regression that controls for the business cycle, monetary policy with fixed effects linking financial conditions and various macroprudential policy tools.² The response of financial conditions to a tightening in prudential policies is quantified using the observation equation:

\begin{matrix} f_{t} = a_{0} + β_{1} p r u d e n t i a l i n s t r u m e n t + {D X}_{t} + ϵ_{t} & (5) \end{matrix}

where f_t captures the change in financial conditions to a change in macroprudential policies (β₁) while controlling for other factors contained in X_t (economic activity, VIX, monetary policy and interest rates). Monthly economic conditions are captured using a mixed frequency coincident index constructed using quarterly GDP and monthly retail sales, industrial production and service sector growth. Prudential policies are traced onto credit and house price growth using the following state equation:

\begin{matrix} \begin{matrix} f_{t} = [\begin{matrix} c r e d i t \\ h o u s e p r i c e \\ N I M \\ N B F C c r e d i t \\ S t o c k p r i c e s \\ M o n e y M 2 \end{matrix}] = [\begin{matrix} λ_{1, t} \\ λ_{2, t} \\ λ_{3, t} \\ λ_{4, t} \\ λ_{5, t} \end{matrix}] f_{t - 1} + ξ_{t} & (6) \end{matrix} \\ w h e r e λ_{i, t} = λ_{i, t - 1} + ϑ_{t} \end{matrix}

22. The focus here in on the 4 prudential instruments that have been used most often in Korea. These include: (i) loan-to-value (LTV); (ii) debt service-to-income (DTSI) and; (iii) real estate tax; and (iv) rise in risk-weights and provisioning. Constraints on household lending, such as limits on loan-to-value and debt-service-to-income ratios, increase resilience to asset price and income shocks and reduce demand for housing loans. To more cleanly isolate prudential policy changes from other macroeconomic effects the model is estimated at a monthly frequency from 2002 to 2016.

23. The macroprudential policy variables from IMF (2018) inform effects per policy action. They do not control for the intensity of policy actions. The confounding effect of the endogeneity of the policies should also be kept in mind when interpreting the results. The introduction of macroprudential policies often reflects the external environment and the perception that surges in bank or bond capital flows may lead to destabilizing capital outflows in any subsequent reversal. To the extent that new macroprudential policies happen only after a period of discussion within the government, central bank, and other public authorities (such as financial regulators), the introduction of such policies often coincides with the late stages of the boom. To the extent that the boom subsides under its own weight, the introduction of the macroprudential policy and the subsequent slowdown of capital flows and credit growth would be a coincidence, not a causal effect. Thus, the results reported herein should be interpreted with some caution.

24. Macroprudential measures have had an effective impact on credit and housing cycles in Korea. The dynamic responses show that changes in loan-to-value limits and risk-weighting appear, with a lag, to have their largest impact on the credit cycle. This outcome is perhaps not surprising, since loan-to-value limits work directly to limit credit demand. Dynamic estimates also show that real estate–specific measures, such as raising real estate–related taxes or tightening the loan-to-value ratio, help directly reduce real estate price inflation. The empirical evidence indicates that LTV and DSTI enhance the banking system’s resilience to house price and income shock, and effectively dampen the procyclicality of credit and asset price growth in Korea. The lagged effect of some prudential measures on credit and asset prices suggests that macroprudential policies need to be forward looking to preempt financial excesses.

How Effective Have Prudential Policies been in Building Financial Buffers

25. Macroprudential policy buffers can help build financial resilience and help in the conduct of monetary policy, particularly during periods of heightened financial frictions. When macroprudential buffers are available in times of financial stress, they can be released to maintain the provision of credit to the economy, thereby reducing the effects of financial shocks on output, and complementing monetary easing that would typically occur in such stressed conditions. Macroprudential buffers can help keep monetary transmission open under such conditions, especially when buffers can be relaxed.

26. Bank based prudential tools, such as capital requirements or loan loss provisioning, are a central part of the macroprudential toolkit in Korea. A macroprudential index is constructed of prudential tools that are principally aimed at building financial sector resilience: capital conversion buffer, reserve requirements, loan loss provisioning and changes in capital requirements, including risk-weights. Raising capital requirements serves both goals of macroprudential policy: preemption and resilience.³ Higher bank capital requirements have several benefits from a financial stability perspective and provide a buffer that absorbs losses—in principal, bank capital plays a preventive role through greater incentives for better risk management. Risk-weights on specific loans, such as mortgages, can be raised to induce banks to hold extra capital and protect against unexpected losses that arise when default rates increase because of an economic downturn. The change in the index shows that such policies have tended to be tightened in periods just before an economic slowdown or during one.

27. The overall efficacy of these prudential measures on financial sector resilience is examined using a regression equation containing a bank-based macroprudential index

\begin{matrix} y_{i, t} = a_{0} + β_{1} p r u d e n t i a l i n d e x + {D X}_{t} + ϵ_{t} & (7) \end{matrix}

where y_i,t is a measure of financial sector resilience and X_t contains controlling factors (market risk premia, monetary policy, economic activity). In this case 4 measures of financial resilience are tested: financial debt, non-core funding, Tier 1 bank leverage and the credit gap. Three of these measures have been shown to be good leading indicators of future financial stress and excess. Periods of faster growth and weaker financial sector resilience is often associated with a change in the composition of the liabilities side of banks’ balance sheets. Banks become increasingly reliant on non-core funding, partly through greater debt issuance, and bank leverage often rises as bank assets increase while tier 1 capital remains unchanged.

28. Bank-based prudential policies help build financial resilience. The empirical evidence suggests that a tightening in bank based prudential policies reduces financial vulnerabilities and creates financial space for banks. Bank leverage and non-core funding decline by a similar magnitude. Financial corporation debt and the credit gap also decline. Together, tighter bank based prudential policies encourage banks to rely more on their core funding. Bank-based prudential policies would also tame the financial cycle by shifting banks’ risk-appetite.

D. Macroprudential Policies and Monetary Policy

29. Monetary and macroprudential policies can sometimes complement each other and yield more effective outcomes. Bruno, Shim, and Shin (2015) find that macroprudential policies are not particularly effective when they lean in a direction opposite to monetary policy. Tightening macroprudential policy tools can dampen real economic activity. However, these effects can be countered by loosening monetary policy at the margin. Macroprudential policy can also give monetary policy more room to pursue its primary objective and help build buffers that can be relaxed in periods of financial stress. Such a policy can help keep monetary policy transmission open, preserving its effectiveness in the event of financial stress.

30. Monetary and macroprudential policies in Korea have often complemented each other since the turn of the century. The chart shows that since 2001 tightening and loosening cycles in macroprudential and monetary policy cycles have tended to move in phase with one another. The pairwise correlation of these two policy cycles is positive and significant at around 0.6 (Table 1). Loosening episodes in macroprudential and monetary policy cycles have often coincided and occurred during periods of slower growth. Such episodes were also characterized by tighter financial conditions, as reflected by slower household debt growth. There are two caveats in the data, however. First, in 2010, as economic activity recovered following the global financial crisis, growth in household debt declined while macroprudential policies were tightened. Second, from late-2014 into all of 2015 economic activity slowed, while growth in household debt picked up as prudential policies were loosened.

Table 1.

Korea: Correlation of Monetary and Macroprudential Changes

31. Macroprudential and monetary policies share similarities and complementarities. Both affect credit demand, albeit in different ways. Monetary policy works by intertemporal allocation, bringing forward spending from the future or pushing it into the future. One way to bring spending forward is to lower interest rates so that economic agents can borrow more sooner. In contrast, macroprudential policy works by restraining borrowing. Monetary policy and macroprudential tools also affect financial risk taking by banks through the so-called risk-taking channel, whereas macroprudential regulation imposes equity constraints.

32. In certain circumstances borrower-based prudential measures and monetary policy can complement one another. The chart illustrates the average response of the change in the credit gap—as a share of GDP—to a tightening in the LTV ratio, with and without monetary policy. The estimates show that the impact of the LTV ratio on the credit cycle is larger when macroprudential and monetary policy push in the same direction. However, these estimates should be interpreted with some caution. The simulations in the chart cover a sample period when fluctuations in real and financial cycles—as measured by real GDP and household debt—have often aligned, resulting in monetary macroprudential policies often pushing in the same direction. While there are an insufficient number of episodes in the current sample to robustly test the proposition, the estimates suggest that in cases where real and financial cycle are not aligned the benefits of complimentary monetary and macroprudential policies diminish.

33. Macroprudential policies can also impact the banking system by affecting bank funding costs through the net interest margin (NIM). Banks NIM is a function of the compensation taken for items such as administrative costs, capital costs, risk premiums, and the banks’ profit margins. Nondynamic macroprudential instruments, such as increased capital or reserve requirements, affect the NIM because they tend to increase banks’ costs, which, to a certain extent, are passed on to customers in the form of an increased interest margin. The rule for regulation through the bank lending interest rate equation, which describes the relationship between monetary policy and macroprudential policy, is expressed as follows:

\begin{matrix} i_{t}^{l e n d i n g} = i_{t} + δ_{t} (z_{t}) . & (\begin{matrix} 8 \end{matrix}) \end{matrix}

Equation (8) expresses banks’ lending rate as a function of the policy interest rate and the interest margin (δ_t). The NIM is influenced by regulation (z_t), which is itself determined by non-time-varying regulations $(\bar{z})$ , the credit gap, and the output gap (Ingves, Apel, and Lenntorp 2010; Shin 2011).

34. Macroprudential policies can impact banks profitability. Estimates from equation (9), which links macroprudential policies and the net interest margin, suggest that the impact of macroprudential policies on the monetary transmission mechanism via the banking system has grown since the Asian financial crisis. The influence of macroprudential policies on financial intermediaries reflects their more aggressive use, improved credibility, and increased financial deepening.

E. Summary and Policy Implications

35. Evidence for Korea suggests that financial stability will not necessarily materialize as a natural by-product of a so-called appropriate monetary policy stance. Although the effects of monetary and macroprudential instruments may overlap, they are not perfect substitutes. Empirical evidence for Korea shows that macroprudential policy have made two active contributions to limit financial risks to the wider economy:

Preempting aggregate weakness by limiting the buildup of risk, thereby reducing the occurrence of crises. Macroprudential policies can reduce the procyclical feedback between asset prices and credit.
Reducing the systemic vulnerability by increasing the resilience of the financial system. By building buffers, macroprudential policy helps maintain the ability of the financial system to provide credit to the economy, even under adverse conditions.

36. Policymakers should be mindful that macroprudential policy is not free of costs and that there may be trade-offs between the stability and the efficiency of financial systems. For instance, when policymakers impose high capital and liquidity requirements on financial institutions, they may enhance the stability of the system, but they also drive up the price of credit. For macroprudential policy to contribute to financial stability and social welfare, its objectives need to be defined clearly and in a manner that can form the basis of a strong accountability framework.

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The neutral rate cannot be directly observed, and the rate is model dependent.

See Teulings and Zubanov (2013) for an explanation of an adjusted local projection method based on Jorda (2005).

It has been argued that higher capital ratios are associated with a higher probability of a crisis. This mechanism suggests that banks raise capital in response to higher-risk lending choices rather than as a buffer against a potential systemic crisis event in the economy. Such a finding is consistent with an empirical reverse causality mechanism reported in the data: the more risks the banking sector takes, the more markets and regulators are going to demand that banks hold higher buffers. See Jordà and others 2017.

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