KYUNGSOO KIM (BANK OF KOREA) AND JAEWOO LEE ( INTERNATIONAL MONETARY FUND)

PERSONAL VIEWS OF AUTHORSNOT TO BE ATTRIBUTED TO THE BOK OR IMF, OR

TO THE POLICIES OF EITHER INSTITUTION

MONETARY POLICY OF THE BANK OF KOREA DURING THE FIRST

SIXTY YEARS(May 31, 2010)

Sixty Years of Dynamic Changes

The Bank of Korea established as the central bank in June 1950

Korean War in the same monthRemarkable economic growth since the

1960sOne of advanced economies by the 2000sDynamic and dramatic developments in both

the society at large and the monetary policy in particular

Helicopter Tour of Sixty Years

Rather quixotic to attempt a full account of dynamic sixty years in some twenty pages

Many excellent books and articles that covered parts of the sixty years

Organizing themes of various phases of the first sixty years of the Bank of Korea, drawing on simple macroeconomic frameworks

Overall, a positive view of the six decades

Overview: four phases

War and its aftermath, 1950 to 1964Big push, 1965 to 1984 (Growth take-off)Liberalization, 1985 to 1998 (Including the crash in 1997-98)Open Macro-economy, since 1999 (Challenges during the Great Recession)

War and Aftermath

Early years of BOK were saddled with war and political turmoil, severely limiting the room for monetary policy.

Bank privatization of 1956 was rescinded in 1962.

The revision of BOK law in 1962 curtailed the power of central bank, while strengthening the influence of MOF as the coordinator of economic policies.

Unpleasant Monetarist Arithmetic

Inevitable monetization of the fiscal deficit

Over 1953-1960, fiscal deficit 23 % of GDP and seigniorage 3 % of GDP

Accompanying inflation rate of 26 percent on average over the same period

0

2

4

6

8

0

10

20

30

40

1955 1960 1965 1970 1975 1980 1985

SEIGN FDEF

Inflation and fiscal deficit

-10

0

10

20

30

40

50

60

70

55 60 65 70 75 80 85 90 95 00 05

CPI inflation rate(KORTEXP-KORTAXR)/KORNGDP*100

Big Push

Under the national economic mobilization program (since 1962), development financing was the defining factor of the financial system.

Despite interest rate liberalization in 1965, and several attempts to develop equity market, financial repression and curb market.

Heavy involvement of government: e.g. nearly 300 monthly meetings on economic trends and exports between 1965 and 1979.

Economic Take-off: 8 percent growth (1965-85)

Fiscal Dominance Lite

BOK supporting 2/3 of export loans over 1966-86

Financing state-led development effort, though not fiscal deficit per se

Large interest rate gaps (10 pp bet general and policy loans, 20 pp bet curb market and general bank loans)

Curb market about 80 percent of M1

0

5

10

15

20

25

30

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1965 1970 1975 1980 1985 1990 1995 2000 2005

CPI Inflation RateSEIGNSEIGNHPF65TO08

Excessive inflation?

Avoided inflation above 20 percent, known to undermine growth.

Lower inflation could have been compatible with fast growth, judging from repeated devaluations and absence of real appreciation despite fast per-capita GDP growth.

.12

.16

.20

.24

.28

.0009

.0010

.0011

.0012

.0013

.0014

.0015

66 68 70 72 74 76 78 80 82 84

RERJP RERUS

200

300

400

500

600

700

800

900

66 68 70 72 74 76 78 80 82 84

Won per Dollar

Liberalization

Liberalization of banks and interest rates since the 1980s, though incrementally

In 1991, a multi-year plan to liberalize interest rates

Unlike the plan, short term interest rate liberalization first, fueling the growth of non-bank financial institutions

Liberalization of financial accounts, including the 1994 lifting of the ceiling on short-term foreign currency borrowings (LT ceiling maintained)

Transition to liberalized economy

Rise in money multipliers

We will look into two regressions:

(1) the interest rate responses to inflation and growth

(2) the real exchange rate responses to macro factors

0

4

8

12

16

0

10

20

30

40

50

55 60 65 70 75 80 85 90 95 00 05

KORM1/KORM0 KORM2/KORM0

Table 2. Exchange Rates and Monetary Policy During Liberalization Phase

-12.98(16.38)

12.02(2.28)

0.00(0.00)

0.77 0.79 0.61 0.71(0.09) (0.08) (0.09) (0.06)

0.70 0.64(0.33) (0.32)

1.35 1.01(1.24) (0.71)

-0.09 -0.64(0.10) (0.17)

0.03 -0.06(0.09) (0.07)

Adjusted R-squared 0.65 0.72 0.71 0.45 0.64

Note: Sample period is 1985Q1--1996Q4.

Call Rate Call Rate

Inflation Rate (4Q ahead)

Real Exchange Rate relative to

USD Call Rate Call Rate

Oil Prices

Relative Productivity

Interest Rate

Call Rate (-1)

Inflation Rate

Real GDP Growth Rate

Ouput Gap

Asian Crisis

Currency and banking crisis in 1997, engulfed in the Asian crisis

Shock liberalization of the economyMuch debate on macroeconomic responsesMuch debate on preceding symptoms and

early warningsEx post, the double hazard of maturity and

currency mismatches

Open Macro-Economy

Inflation targeting in 1999, with the call rate as policy instrument of the BOK

Flexible exchange ratesGreatly liberalized financial accountsInterest rate and exchange rate regressions,

confirming inflation targeting mode and increased exchange rate flexibility

Interest rate and FX regressions

Irate = constant + a*irate(-1Q) + b*inf +c*(growth rate or output gap)

Irate = constant + a*irate(-1Q) + b*inf(+4Q) +c*(growth rate or output gap)

RER (relative to the U.S.) = constant + a*oil price + b*productivity differential + c*interest rate differential

Table 3. Exchange Rates and Monetary Policy During Open Economy Phase

-12.49(7.80)14.14(3.87)-0.04

(0.01)0.73 0.80 0.62 0.79

(0.05) (0.05) (0.04) (0.03)0.27 0.03

(0.08) (0.09)0.56 0.43

(0.14) (0.08)0.05 0.02

(0.01) (0.01)0.09 0.06

(0.022) (0.01)

Adjusted R-squared 0.77 0.85 0.87 0.71 0.8

Note: Sample period is 1999Q1--2008Q4.

Real Exchange Rate relative to

USD Call Rate Call Rate

Oil Prices

Relative Productivity

Interest Rate

Call Rate (-1)

Call Rate

Inflation Rate

Inflation Rate (4Q ahead)

Real GDP Growth Rate

Ouput Gap

Call Rate

Great Recession

Following the freeze of the financial system in the fall of 2008, triggered by Lehman collapse

In 2009, the world output contracted by ½ percent and trade by 11 percent

Sharp effects on Korea as a trading nation, large exchange rate depreciation and financial outflow, reminding of the Asian Crisis

But different policy responses and net effects

External and Internal Developments

800

1,000

1,200

1,400

1,600

1,800

-.3

-.2

-.1

.0

.1

97 98 99 00 01 02 03 04 05 06 07 08 09

ER542 FA542/(1000*NGDP542/ER542)

2

3

4

5

6

7

8

9

0

5

10

15

20

25

30

35

97 98 99 00 01 02 03 04 05 06 07 08 09

UNEMP542 CALL542

Fault lines that surfaced

Vulnerability in the external borrowing of banking sector—currency mismatch in short-term external balance sheet

Volatility in international financial flowsSide effects of maturity and currency

transformationMaturity and currency transformations are

arguably the bread and butter of international financial intermediation.

What options? (reminder—Personal Views)

Reserve accumulation—how much is enough? A more efficient alternative?

Deepening of the Won FX market—very incremental process

Prudential regulation of international financial flows—gray area between regulation and controls. Ongoing debate on the roles of control as short-term measures.

Heterodox approach, while “emerging”

Conclusion

The history of the Bank of Korea in the first sixty years is a testimony to the roles of central bank in the midst of rapidly evolving economic and social circumstances.

We use the prism of several macroeconomic frameworks, hoping for further analysis.

Challenges of navigating through ongoing evolutions in the global financial markets.

Strong start on the second sixty years.