Covered Interest Arbitrage and the Currency Crisis in Korea
In-June Kim* and Jung Seok Woo** 1999. 8
** Abstract ** This article closely examines the maintenance of the covered interest parity during the course of the currency crisis in Korea, and analyzes the movement of the covered interest differential(CID) in an effort to draw out some policy implications. This article also takes a thorough study of whether a self-fulfilling expectation has actually been a triggering cause for the crisis in Korea. During the course of the currency crisis in Korea, it seems that a substantial discrepancy of CID has been persistent for a considerable period of time. This phenomenon can be attributed to the following two factors : expectations for a devaluation and the risks regarding a sovereign bankruptcy. This article also analyzes the relationship between CID and capital flows, and elicits some evaluations on the high interest rate policy implemented throughout the IMF supported program. In the course of the Korean currency crisis, most of the capital outflows took place in the areas of portfolio investment and bank loans, with the ratio of outflow of the latter outweighing that of the former. The policy objective of the high interest rate policy was to prevent capital outflows by improving the rates of return at home. Nevertheless, this attempt proved futile, or at most limited, since it could not provide any explicit policy channels to prevent the refusal of credit rollover. Moreover, it failed to prevent further capital outflows in portfolio investment, since it could not offset the risks of sovereign default.
* Faculty of Economics, Seoul National University, Seoul, Korea;
[email protected] ** Graduate Student(Expected to graduate in 1999. 8), Graduate School of Economics, Seoul National University, Seoul, Korea;
[email protected]
1
Covered Interest Arbitrage and the Currency Crisis in Korea
I. INTRODUCTION ................................................................................................... 2
II. INTEREST ARBITRAGE : DEFINITION AND IMPLICATIONS ................... 3 1. COVERED INTEREST ARBITRAGE(CIA).................................................................... 3 2. UNCOVERED INTEREST ARBITRAGE (UIA) .............................................................. 3 3. INTEREST ARBITRAGE AND THE CURRENCY CRISIS .................................................. 4
III. COVERED INTEREST ARBITRAGE AND THE CURRENCY CRISIS IN KOREA ....................................................................................................................... 6 1. COVERED INTEREST RATE DIFFERENTIAL(CID) DURING THE CURRENCY CRISIS IN KOREA ....................................................................................................................... 6 2. CHRONOLOGICAL ANALYSIS OF CID..................................................................... 11
IV. SELF-FULFILLING EXPECTATIONS IN THE CURRENCY CRISIS ........ 15 1. OVERVIEW OF THEORETICAL MODELS OF CURRENCY CRISIS IN RELATION TO SELFFULFILLING EXPECTATION ....................................................................................... 15 2. MOVEMENTS OF CID AND SELF-FULFILLING EXPECTATION ................................... 18
V. HIGH INTEREST RATE POLICY DURING THE CURRENCY CRISIS: ASSESSMENT.......................................................................................................... 18 1. CAPITAL ACCOUNT IN THE BALANCE OF PAYMENTS TABLE AND INTERNATIONAL CAPITAL FLOWS ...................................................................................................... 19 2. TRENDS OF CAPITAL OUTFLOW IN THE COURSE OF THE CURRENCY CRISIS............. 20 3. ANALYSIS OF THE EFFECT OF HIGH INTEREST RATE POLICY ON CAPITAL OUTFLOW 21
VI. SUMMARY AND CONCLUSION .................................................................... 24
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I. Introduction
The main purpose of this article is to examine closely whether the covered interest parity has been maintained during the course of the currency crisis in Korea, and to calculate the covered interest differential(CID) in an effort to analyze its movements and draw out some implications. This article also takes a thorough study of whether a self-fulfilling expectation has actually been a triggering cause for the crisis in Korea. In addition, we shall also analyze the relationship between CID and capital flows and elicit some evaluations on the high interest rate policy implemented throughout the IMF supported program. Evaluations on the high interest rate policy will have to be considered in tandem with the side effects it caused throughout its implementation. During the course of the currency crisis in Korea, it seems that the substantial size of CID has been persistent for a considerable period of time. This phenomenon can be explained by two factors, namely, expectations of a devaluation and the risks regarding a sovereign bankruptcy. This article comprises of six chapters. After this brief prefatory section, Chapter 2 will introduce the definition and the traditional interpretations of interest arbitrage and address the effects of a currency crisis on the interest arbitrage. Chapter 3 will then analyze the trend and the underlying causes of covered interest differential shown during the currency crisis.
The covered interest differential will be
decomposed into interest differential and forward discounts between Korean and the US currency. In Chapter 4, we will look through how major theoretical models handle the issue of selffulfilling expectation as a triggering factor of a currency crisis, and examine whether a selffulfilling expectation was actually a triggering cause for the crisis in Korea. In Chapter 5, we will categorize international capital flows and draw out some evaluations on the effectiveness of the high interest rate policy and analyze its adverse side effects. In Chapter 6, finally, we will make a conclusion on this article.
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II. Interest Arbitrage : Definition and Implications 1. Covered Interest Arbitrage(CIA) Let’s take a closer look at covered interest arbitrage with the following example. An American investor who wants to make an investment of X dollars for three months is supposed to select between a dollar-denominated American asset and a won-denominated Korean asset. The annual interest rates for the dollar-denominated American asset and the won-denominated Korean asset with 3 months maturity are i % and i ∗ %, respectively. The letters ‘ s ’ and ‘ f ’ stand for won-dollar spot exchange rate and 3-month won-dollar forward exchange rate. When this investor makes an investment in the dollar-denominated asset, he makes a profit of (1 + i ∗ / 400) X dollars after three months of investment. On the other hand, when he invests his
money in the won-denominated Korean asset and eliminates exchange risks by using forward markets, he has to take into account the following three steps of investment at the time of his decision. First of all, he has to convert the dollars into Korean won, which would then be denoted as X ⋅ s won. Investing into the won-denominated Korean asset, the return after three months
would then become b 1 + i / 400g X ⋅ s won. Finally, he has to re-convert the amount into dollars,
and in order to avert the exchange risks during the conversion by making a forward contract, the 1 dollars. final return on his investment would amount to b 1 + i / 400gX ⋅ s f If the restrictions on cross-border international capital movement do not exist and the risks of
investment are limited to exchange risks only, then the rates of return from investing in any two countries would become identical. We call this covered interest parity, and when this parity holds the returns from domestic assets and foreign assets become equal. In terms of equation,
b
g
(1 + i ∗ / 400) X = 1 + i / 400 X ⋅ s / f . Covered interest arbitrage makes them equal.
When applied to advanced countries where the movement of capital is relatively free, it has been shown no substantial deviations from the covered interest parity1.
2. Uncovered Interest Arbitrage (UIA) In the aforementioned covered interest arbitrage, the American investor can eliminate the exchange risks by making a forward contract. Nevertheless, in case of uncovered interest arbitrage(UIA), the exchange risks are not eliminated since the investor does not participate in the forward exchange markets. Therefore, denoting ‘ se ’ as expected value of the spot exchange rate after three months, the notion that the uncovered interest parity holds would imply that the 1
See Galitz(1994). 3
4
s equation e 1 + i ∗ / 400jX = b 1 + i / 400g X e would thus hold. s
In reality, the verification of uncovered interest parity in the international financial market would be a testing of efficiency in the market. When the covered interest parity holds, the uncovered interest parity would mean that the forward rate ( f ) and the expected value of the future spot rate( se ) are identical. However, it would be generally infeasible to make a statistical test on this relationship( f = s e ), since it would be impossible to make an ex post observation on the expected value of future spot rate( se ). Generally, the failure of uncovered interest parity is attributed to two factors, namely, the risk premium on foreign exchange risk and systematic expectation errors by market participants.
3. Interest Arbitrage and the Currency Crisis Failure of covered interest arbitrage could be explained by the following factors : (1) differences in maturity, credibility, and liquidity between two different assets, (2) transaction costs and tax rate differentials, or asymmetry between countries, (3) regulations on free capital movement by the government, and (4) differences in political risks between two countries. Let’s take a look at how these factors tend to move during the course of a currency crisis. First of all, maturity is not influenced by the currency crisis, while the liquidity and credibility of the crisis-struck country tend to plummet significantly during the crisis. Next, transaction costs and tax rate differentials are not substantially influenced during the crisis. Third, regulations on free capital movement by the government are chiefly expressed as limits on foreigners’ holding of domestic stocks or ceilings on the investment by foreigners in bond markets. These kinds of regulatory measures, however, do not make any difference at the onset of the crisis. In the case of Korea, where the regulations on short term capital inflow have been gradually lifted by opening the short term financial market. Finally, differences in political risks between two countries, such as sovereign default risk, debt in arrears, and capital controls on capital flight, can be factors that break down the covered interest parity during a currency crisis. The substantial deviation from covered interest parity following a currency crisis, could be attributed to the aggravation of credibility of the financial institiutions and the augmentation of political risks in the crisis-struck country. Since the difference in rates of return in case of the uncovered interest arbitrage is made up of covered interest arbitrage and exchange risk premium2, one can observe the effect of changes in exchange risk premium on the expected rate of return from the analysis of uncovered interest
2
log
Le1 + i∗ j− b1 + igs O= i ∗ − i − s + se = oi ∗ − i − s + f t+ ose − f t M se P N Q 4
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arbitrage.
In other words, the uncovered interest arbitrage provides us with an alternative
approach to analyzing the channel in which the investment decision is affected by the change in exchange risk premium, which the covered interest arbitrage was unable to show. However, in the case of dealing with the currency crisis by using the uncovered interest arbitrage, the main difficulty lies in the statistical problems of determining the expected value of future exchange rates. On the other hand, when one focuses on the effect of the sovereign default risks on interest arbitrage during the course of the currency crisis, it would become more suitable to concentrate on the covered interest arbitrage As mentioned above, there are certain difficulties in analyzing a currency crisis with uncovered interest arbitrage as the tool of analysis.
On the other hand, there are several
advantages in approaching a currency crisis using the covered interest arbitrage. Above all, one can eliminate any possibilities of exchange rate risks by using forward rates at the time of the investment instead of relying on the future expectation of exchange rates. In this respect, the covered interest arbitrage would thus reflect the investor’s perspective on the sovereign default risk or on the debt in arrears. Secondly, the covered interest arbitrage does not result in any problems of discrimination between investors, as is the case with uncovered interest arbitrage. Finally, the covered interest arbitrage would act as a fundamental criteria for investment decisions, since it employs forward rates already determined in the market itself.
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III. Covered Interest Arbitrage and the Currency Crisis in Korea 1. Covered Interest Rate Differential(CID) during the Currency Crisis in Korea This section will outline some characteristics of covered interest differential(CID) during the currency crisis in Korea in comparison with the pre-crisis period, and analyze the CID by decomposing into domestic and international interest rate differential and forward discount. In order to make an observation of the CID between a dollar-denominated American asset and a won-denominated Korean asset during the currency crisis, namely, from August 1996 through February 1999, we select a three-month Korean CD and a three-month US Euro deposit as representing domestic and international assets, respectively. The CID would be indicated in an annualized percentage form, as is the norm in international finance, and would be defined as follows: CID =
LF i ∗ I F i I s O . 1+ × 400 − 1+ M G H 400 JKf P H 400 JK G M P N Q
Here ‘ i ’ and ‘ i ∗ ’ stand for the annual interest rates for the three-month Korean CD and three-month US Euro deposit, while ‘ s ’ and ‘ f ’ represent the won/dollar spot exchange rate and won/dollar three-month forward exchange rate3. Since the interest rate would be expressed in percentage on an annual basis, we will divide it by 400 in order to express it in terms of a threemonth period. Now, the expression in the large bracket([ ]) stands for the covered interest differential between the two assets for the three month period. By multiplying by 400, the covered interest rate differential would be denoted as a percentage on an annual basis. If the CID exceeds zero(CID>0), then it will be more profitable to invest in the three-month US Euro deposit; otherwise(CID0) to a negative value(CID0) with its deviation steadily converging to zero. During the transition of the CID from negative to positive, we can deduce that the high interest rate policy had taken a leading role. On the other hand, the movement of the CID was more directly influenced by the forward discount (or premium) rather than by the interest rate differential.
2. Chronological Analysis of CID From a long time span from August 1, 1996 through March 1, 1999, we can make a chronological classification into six disparate, but consecutive periods according to the movement of the CID. As shown below in [Table 1], each period is characterized by its duration, average value of CID, standard deviation, and other references. [Table 1] Chronological Classification of the Currency Crisis in Relationship with Covered Interest Differential
Period
Duration
Average (%)
Standard
References
Deviation 0
08/01/96 – 07/15/97
-1.73
–
2.623
Pre-crisis period
1
07/16/97 – 10/16/97
5.13
+
3.45
Bankruptcy of Kia Motors, Diffusion of market unrest
2
10/17/97 – 12/14/97
31.31
+
18.73
Speculative attacks, Distortions in exchange rates and domestic interest rates
3
12/15/97 – 04/12/98
-6.49
–
24.28
Implementation of the IMF program, Adoption of floating exchange rate and high interest rate policies
4
04/13/98 – 09/19/98
11.94
+
8.49
Continuous decline in interest rates
5
09/20/98 – 03/01/99
0.85
+
4.63
Recovery of market stability
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The currency crisis in Korea can be assessed from Period 2 to 4 in [Table 1], during which the movement of the CID shows a drastic deviation from the period before and after. As can be seen from the average CID for Period 0 (–1.73%) and Period 1 (5.13%), the movement of the CID prior to the crisis had been relatively stable. However, after the onset of the crisis from late October to mid-December 1997, in Period 2, the average CID had shot up to 31.31% with highly unstable fluctuation during the period. In Period 3, from mid-December to early April 1998, the movement of the CID had reversed from positive to negative, with even higher unstability of movement. While the average CID during this period recorded –6.5%, it had marked –11.3% from the end of 1997 to January 1998. The negative value of the CID, however, was once again reserved to positive in Period 4, with its average recording 11.9% during the period from mid-April through mid-September 1998. Finally, in Period 5, we can witness the average CID and its deviation from the mean steadily gaining stability and returning to the pre-crisis level. In summary, we can assess that the Period 2 to Period 4, where the movement of the CID had been off the parity, exactly matches the currency crisis period in Korea. Next, we shall investigate why the CID took on different forms during each period. First of all, in order to understand the aspect of the CID during Period 2, one should bear in mind the following factors. During Period 2, the exchange rate was determined within a daily band under Market Average Exchange Rate Regime and it was impossible for the Korean government to interfere in the offshore forward market (NDF). On the other hand, the interest rate for the Euro deposit was given as an independent variable, while the domestic interest rates were stabilized at around the 12~13% level. Under this circumstance, rumors began to spread that the Korean financial institutions were having difficulties securing international liquidity following the bankruptcy of Kia Motors and the growing concern over non-performing loans in the financial sector.
In this respect, the foreign
investors began to anticipate that the Korean government would either drastically devalue the Korean won or shift to a floating exchange rate regime, and the offshore futures markets were beginning to reflect their anticipations. As a result, the forward exchange rate in the NDF( f ), began to rise. If we suppose that the covered interest parity(CIP) had taken hold before the shocks hit the foreign exchange market, then the rise of ‘ f ’ implies the following inequation : F i I F i I s . As a result, the CID would rise significantly and net capital outflow would G1 + J> G1 + J
H
400
KH
K
400 f
occur since it would be more profitable to invest outside Korea.
Putting it differently,
expectations for devaluation of the Korean won had caused the forward exchange rate to rise, making it profitable to engage in covered interest arbitrage. Generally, when covered interest arbitrage takes place in the foreign exchange and bond
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markets, the covered interest parity gradually recovers and returns to its normal track. Theoretically, it can be shown by the rise of ‘ s ’ and ‘ i ’ and the fall of ‘ f ’ and ‘ i ∗ ’ following net capital outflow. Since both domestic and international interest rates, namely ‘ i ’ and ‘ i ∗ ’, were stable, in order to bring back CIP through arbitrage, there had to be an adjustment through the foreign exchange market.
In other words, in order to return to the equation, that is,
F i I F i I s , (1) ‘ f ’ should fall, or (2) ‘ s ’ should rise, or (3) the ratio of the two ( s / f ) 1+ =G 1+ J G H 400 JK H 400 Kf
should rise. However, none of these things took place.
Above all, the forward exchange rate did not fall, but rather kept rising due to a wide spread of anticipation in the NDF market of a devaluation or shift to free-floating exchange regime. In addition, the Korean government at that time tried to maintain stability in the foreign exchange market and the spot exchange rate was moving within a limited band under the Market Average Exchange Rate Regime. Therefore, in spite of large capital outflows during this period, the CID was kept at a high margin due to the increasing discrepancy between the forward and spot rates and the restrictions on participation in the NDF market4. In Period 3, after Korea’s application for the IMF-supported program, the exchange rates were freely determined in the markets and domestic interest rates rose to an average of 25%, accepting the advice given by the IMF. The risks of sovereign default caused by the heavy burden of short-term liabilities and the risks of debt in arrears had been alleviated after the emergency actions taken by the IMF and G7 countries on December 24, 1997. During this period, the spot exchange rate soared and its wide discrepancy with the forward exchange rate lessened, and domestic interest rates were increased following the IMF advice for contractionary monetary policy.
In terms of CID calculation, these changes in economic indicators would be
reflected as a rise in the domestic interest rate( i ) and the ratio of spot and forward exchange rates( s / f ). As a result, the rates of return for domestic and international assets would be i I F i Is reversed, or in terms of inequation, F G1 + J< G1 + J , thereby making it more profitable to invest in domestic assets.
H
400
KH
K
400 f
Nevertheless, fearing risks of sovereign default, most foreign investors were still unwilling to re-invest into Korean assets, even though the CID was kept at substantially below the 0 % level. For instance, during January 1998, the average CID was –11%, making it more profitable to invest in the Korean CD, yet in reality foreign investors’ investment in short-term bonds recorded 850 million dollars of capital outflow during that time. Although it was more profitable to invest in Korean assets as shown in CID movements, foreign investors were reluctant to come back to Korea because they feared the default risks of bond-issuers, or even more seriously, the risks of
4
Only large foreign banks with credit ratings of higher that AA are allowed access to the offshore NDF market. During the currency crisis in Korea, therefore, Korean financial institutions could not participate in the offshore NDF market due to their low credit ratings and restrictive domestic laws.
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sovereign default. In other words, due to the country risk and political risks, which increased abruptly in the course of the currency crisis, the covered interest arbitrage failed to take hold and the CID had been continuously maintained in the negative. In Period 4, the CID again reverts to a positive level, implying that it had become more profitable to invest in the US. In spite of the downward trend of the exchange rate, this reversal was mainly attributable to the market anticipation of a rise in the future exchange rate influenced by the eruption of financial crisis in Latin America and Eastern Europe, which widened the discrepancy between forward and spot rates. In addition, it could also be attributed to continual lowering of the interest rates by the Korean government to prop up the sluggish real sector. [Table 2] summarizes the situation during the currency crisis mentioned so far.
[Table 2] Analysis of CID and its Movements during the Currency Crisis
Period 2
Period 3
Period 4
10/17/97 – 12/14/97
12/15/97 – 04/12/98
04/13/98 – 09/19/98
Duration Direction of
More profitable to invest in
More profitable to invest in
More profitable to invest in
Investment
US Euro deposit
Korean CD
US Euro deposit
Determinant of
Anticipations of devaluation
Rise of spot exchange rate
Anticipations of a rise in
Trend in CID
or shift to free-floating
due to the shifting of
future exchange rate due to
exchange rate regime;
exchange rate regime to
financial crisis in Latin
free-floating one;
America and Eastern
High interest rate policy
Europe;
Reflection on the forward exchange rate
Reflection on the forward exchange rate
Factors for
Inflexibility of domestic
Risks of sovereign default
Sustaining Trend
interest rates;
domestic interest rates;
Restrictions on participation
Restrictions on participation
in the NDF market
in the NDF market
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Continuous decrease in
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IV. Self-Fulfilling Expectations in the Currency Crisis This chapter will examine whether self-fulfilling expectations for devaluation were actually a triggering factor in the Korean currency crisis by investigating the movements of the CID. At first, we shall outline some of the theoretical models of currency crisis in relation to self-fulfilling expectation. After that, we will make assessment as to whether this self-fulfilling expectation eventually triggered the currency crisis, by examining the linkage between forward premium and capital outflow.
1. Overview of Theoretical Models of Currency Crisis in Relation to Self-Fulfilling Expectation Several theoretical models of currency crisis can be listed as follow : (1) The 1st Generation Model (Krugman, 1979), (2) The 2nd Generation Model (Obstfeld, 1994), (3) Sudden Death Model (Sachs, Tornell, & Velasco, 1996), (4) Moral Hazard Model (Krugman, 1998), (5) Creditors’ Panic Model (Sachs, 1998), (6) Twin Crises Model (Goldfajn & Valdes, 1997), and (7) Capital Liberalization and Boom-Bust Cycle Model (In-June Kim, 1998). Each of them tries to elucidate the causes of a currency crisis by developing a model extracted from the characteristic aspects that have occurred in crisis-struck countries. According to the 1st Generation Model, the crisis-struck government uses up its foreign reserves and faces steady limitation on borrowing from abroad in a futile effort to fix and maintain the exchange rate. However, when the reaction in the foreign exchange market takes the form of speculation, a currency crisis inevitably takes place. As the foreign reserves are drained and shift to a free-floating exchange regime is expected, the exchange rate rapidly rises and the value of domestic currency subsequently falls, which could inflict heavy losses on financial assets denominated in the domestic currency. Naturally, in an effort to evade any possible losses, investors convert their assets denominated in domestic currency into a hard currency before all the foreign reserves are used up, or before the government gives up defending its fixed exchange rate regime. We call this ‘ speculative attack’. This speculative attack is triggered at a point when the conditions for securing against any losses on the investors’ side, or putting it differently, the conditions for the convergence of exchange rates under a fixed exchange rate regime and flexible exchange rate regime, are met. Specifically, Krugman cites foreign reserves and the ratio of total real wealth kept in domestic currency and in foreign currency by domestic residents, etc. as the determinants for deriving the point of speculative attacks. The 2nd Generation Model approaches currency crisis from a cost-benefit analysis of 15
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maintaining a fixed exchange rate regime. Obstfeld (1994) supposed that the domestic output is an increasing function of the price level, which corresponds one-to-one with exchange rates, and a decreasing function of nominal wage rate, which is exogenously fixed before the government picks the exchange rate as its tool for policy implementation. The government’s loss function is determined by (1) the discrepancy between targeted output level and realized output level, and (2) the inflation rate.
The government implements its exchange rate policies with regard to
minimizing loss incurred in its loss function. If the government decides to weather through an external demand shock without adjusting the exchange rate, the outcome will be a wide discrepancy between targeted output level and realized output level. If, on the contrary, the government adjusts the exchange rate, then this adjustment results in inflation corresponding to the margin of adjustment in the exchange rate, along with fixed costs of adjustment.
The
government, therefore, balances costs against benefits and decides whether it should maintain the exchange rate or leave it to adjustment.
In addition, the 2nd Generation Model shows how an
unexpected event, such as the change in expected inflation in response to negative shocks, forces an adjustment of exchange rates. The Sudden Death Model was proposed to explain the Mexican Peso crisis in 1994. Under the circumstances of decreasing foreign reserves and increasing short-term external liabilities, the economy might fall into a condition of ‘multiple equilibria.’ In this case, the Sudden Death Model shows how the expectations for depreciation can lead the economy into ‘bad equilibrium’ and eventually into depreciation. Under the Sudden Death Model, the government aims to minimize interest payment on its liabilities, which it must make by means of either a real tax or an inflation tax.
If the costs incurred from devaluation are relatively small, the government
decides to devalue its currency, and the loss incurred to the government differs depending on the expectations formed by the private sector. Like the 2nd Generation Model, the Sudden Death Model emphasizes the expectation of depreciation in that they both underscore the possibility of a self-fulfilling currency crisis caused by expectations of depreciation by the private sector. The Moral Hazard Model proposes that a currency crisis is mainly the result of a phenomenon in which the investors either ignore or underestimate the risks accompanying investment and emphasize only the rate of return when the government gives an implicit guarantee on the liabilities of financial institutions. When the effectiveness of this implicit guarantee no longer holds, the risks of the financial institutions abruptly soar, and if the market anticipates that the government will deal with this problem by taking an expansionary stance in its monetary policy, then this anticipation leads to an expectation of depreciation. This model cites that an expectation of depreciation, which can be observed throughout a currency crisis, could be triggered by moral hazard among investors, rising from implicit government guarantee. The modern approach to the Creditors’ Panic Model mainly interprets the Asian currency
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crisis as a kind of bank-run phenomenon. Due to their heavy exposure to short-term external liabilities and difficulties in securing sufficient liquidity, domestic financial institutions might fall in danger of bankruptcy when foreign investors refuse to allow rollovers5. The modern approach to the Creditors’ Panic Model proposes that abrupt capital flight facilitates the expectations of depreciation, thereby causing a currency crisis. The Capital Liberalization and Boom-Bust Cycle Model is derived from the fact that the crisis-struck Asian countries had pursued capital liberalization policies, and explains the causes of a currency crisis through focus on the correlation between the exchange rate and the accumulation of external debts.
When the discrepancy between domestic and international
interest rates is large and due to the difference in stage of economic development, it is difficult to narrow the interest rate gap with capital flows. On the other hand, when the government gives an implicit guarantee of the corporate and financial sector, the risks accompanying an investment might become underemphasized.
The interest rate gap between developing countries and
advanced countries also facilitates cross-border capital flows, and more capital is invested into developing countries where the expected rate of return is relatively higher. The large amount of capital inflow causes the value of the domestic currency to rise and the money supply to expand, which is channeled into inflation and boom in the real estate and stock markets. This also worsens the current account. However, with the rapid deterioration in balance of payments if more foreign investors cast their doubts on the fundamentals of the economy, and finally if they believe that the risks have become too large to offset the advantages of the interest rate differential, they begin to retrieve their capital. At this point, an additional shock to the economy would fuel speculative attacks for depreciation, and foreign capital would be rushed out of the country even faster, ultimately leading to a currency crisis. However, if the capital outflow ends at an incipient stage eliminating bubbles inherent in the economy, the country can recover its competitiveness and restore its fundamentals.
Foreign investors would then regain their
confidence in the economy and foreign capital would rush back in due to the interest rate differential. The economy would be brought back to its previous path. The Twin Crises Model emphasizes the intermediary function of financial institutions arising from a mismatch of maturity between assets and liabilities, which also plays a leading role in the expansion of in- and outflows of capital. The problems of this intermediation manifest themselves when an external shock hits an economy and leads to a liquidity shortage and subsequently to a bank-run by foreign investors. This bank-run on domestic financial institutions inevitably drains the foreign reserves of the central bank and gives pressure for depreciation. Once again, expectations of depreciation trigger capital flight and the country is faced with currency crisis.
5
See Park, Dae-Keun(1999).
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2. Movements of CID and Self-Fulfilling Expectation The models outlined above all have in common that expectations of depreciation act as a triggering factor for currency crisis. Needless to say, each model takes a different approach on how the expectations are formed, and the Sudden Death Model even concludes that the formation of these expectations was not simply one aspect of a currency crisis, but the foremost determinant.
During the pre-crisis period, the expectations of depreciation would lead the
economy to ‘bad equilibrium’ and to currency crisis in the end. Especially, in the case of the Korean currency crisis, it is important to verify how the underlying causes behind the formation of expectations of depreciation and the expectations themselves developed into a self-fulfilling expectation. Expectations of depreciation were fueled from a shortage of international liquidity rising from various factors explained by the aforementioned models. Particularly, as foreign investors began to cast their doubts on Korea’s ability to secure sufficient international liquidity, the expectations of depreciation grew even more rapidly, as can be witnessed from the steep rise in the forward exchange rates. In the case of Korea, the forward premium in the CID accounts for the expectations of exchange rate depreciation. We can see that these expectations developed into self-fulfilling expectations by observing the sharp increase in the CID following a rise in forward premium just before the crisis, which resulted in faster capital outflow and eventually in a currency crisis. As the exchange rate regime shifted to a free-floating regime, the exchange rate rapidly rose to the level of the forward exchange rate, and the expectations of depreciation led to a currency crisis in the end. In summary, the expectations of depreciation can be realized as a sharp rise in forward exchange rates, resulting in an abrupt capital outflow and a currency crisis.
V. High Interest Rate Policy during the Currency Crisis: Assessment In late December 1997, when the Korean currency crisis was at its zenith, the Bank of Korea adopted a high interest rate policy, advised by the IMF, and hiked call rates from the 10% level to as high as the 35% level. For four months, until April 1998, call rates exceeded the 20% level, and this high interest rate policy has since been a core of criticism against the IMF-supported
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macroeconomic policies. In this chapter, we shall categorize capital flows and analyze the correlation between international capital flows and the CID, and make assessment on the effectiveness of the high interest rate policy.
1. Capital Account in the Balance of Payments Table and International Capital Flows International capital flows included in the capital account of the balance of payments table can be categorized into the following: (1) foreign direct investment(FDI), (2) portfolio investment, and (3) other investment. [Table 3] decomposes total foreign capital inflows into Korea into three different categories and shows ratios for each of them to GDP. Beginning from 1990, the total foreign capital inflow had increased steadily from 6.5 billion dollars to 48 billion dollars in 1996, when it amounted to almost 10% of total GDP. Looking into the individual ratios in 1996, approximately 4.4% of GDP was invested in the form of portfolio investment, whereas 5.1% of GDP was invested in the form of credit extension to financial institutions. [Table 3] Categorization of Capital Inflow into Korea since 1990
Total foreign capital inflow
1990
1991
1992
1993
1994
1995
1996
1997
6.507
10.519
10.605
9.686
22.59
37.101
48.079
6.814
0.31
0.40
0.24
0.18
0.21
0.39
0.48
0.64
0.09
0.79
1.61
3.17
2.14
3.04
4.37
2.78
2.17
2.38
1.60
-0.44
3.58
4.70
5.07
-1.88
2.57
3.58
3.44
2.91
5.93
8.13
9.92
1.54
(billion USD) Foreign direct investment /GDP Ratio(%) Foreign securities investment /GDP Ratio(%) Bank borrowing and others /GDP Ratio(%) Total foreign capital inflow /GDP Ratio(%)
(Source) IFS CD-ROM
In general, foreign direct investment is a form of investment lacking in liquidity. On the other hand, portfolio investment, which can be divided into stock investment and bond investment, is relatively more liquid as long as the market size is large enough to absorb the investment. In
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the case of Korea, however, there had been restrictions on portfolio investment by foreigners such as a ceiling on foreigners’ holdings of domestic stocks and a closed short-term bond market before the crisis. Moreover, since portfolio investments by foreigners were denominated in domestic currency, foreign investors faced exchange risks during a currency crisis if they were to withdraw their capital and convert it into dollars. Keeping in mind this circumstance, it can be assessed that the liquidity of portfolio investment by foreigners, regarding their withdrawal of invested capital, was seriously hampered. Among the categories for other investment, bank loans accounts for a lion’s share and are normally more liquid than other type of capital flow. In this case, the loan contract is usually denominated in dollars with interest rates in the form of the London InterBank Offered Rate(LIBOR) plus a spread; thus, it will not be severely affected by depreciation of the domestic currency in case of the withdrawal of invested capital. In summary, the costs accrued from withdrawal of capital in other investment categories will be less than those from withdrawal of capital in portfolio investment. Moreover, considering the fact that short-term bank loans had a large share in Korea’s overall external liabilities, it is easy to anticipate that the capital flight during the currency crisis took place mainly in the categories of other investment. For a sound economy, the loans from financial institutions of advanced countries are easily rolled over. Yet, when these financial institutions suddenly decide to refuse rollovers, borrowers have no choice but to make redemption at maturity, or otherwise declare bankruptcy or carry the loans into arrears.
2. Trends of Capital Outflow in the Course of the Currency Crisis [Figure 7] shows the movement of foreign direct investment, portfolio investment, and bank loans during a time span from April 1997 to January 1999. At first, we can identify that foreign direct investment had been steady despite of the currency crisis. As for portfolio investment, there were capital outflows of around 1.56 billion dollars and 1.24 billion dollars in November and December, 1997, respectively, due to the withdrawal of invested capital by foreigners. On the other hand, in the categories of other investment, there was a capital flight of around 5.01 billion dollars and 12.07 billion dollars during the same period. By looking at the numbers, we can figure out that the capital flight in the categories of other investment, either by means of refusal to rollover or withdrawal of bank loans by creditors, outweighed that of portfolio investment by approximately threefold in November, 1997 and 9.8fold in December, 1998.
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[Figure 7] Movement of Foreign Direct Investment, Portfolio Investment, and Bank Loans during the Korean Currency Crisis (Unit: million dollars) 4000
0
-4000
-8000
-12000
-16000 97:04
97:07
97:10
98:01
Foreign Direct Investment
98:04
98:07
Portfolio Investment
98:10
99:01 Bank Loans, etc
[Table 4] shows the amount of capital flow at the culmination of the currency crisis in Korea, during three months from November, 1997 to January, 1998. According to this table, the amount of withdrawal of bank loans for the three-month period outnumbers the amount of capital outflow in portfolio investment by a multiple of seven. We can deduce from this fact that the capital outflow during the currency crisis in Korea took mainly the form of withdrawal of bank loans by foreign financial institutions. [Table 4] Capital Flow at the Culmination of Currency Crisis (Unit: million dollars)
Period
Foreign Direct Investment
Portfolio Investment
Bank Loans, etc.
97/11,12 & 98/1
783.7
-2743.5
-19103.3
3. Analysis of the Effect of High Interest Rate Policy on Capital Outflow At the end of December, 1997, the Bank of Korea hiked call rates to as high as 35%, as an emergency measure after policy consultation with the IMF. After that, major interest rates in the markets rose to the level of 30% at the end of 1997, and stayed above the 20% level for more than four months until mid-April, 1998. The adoption of a high interest rate policy in an effort to stabilize the foreign exchange market can be explained by the following theoretical considerations. First of all, a short-term
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hike in domestic interest rates would subsequently raise the rate of return on domestic assets and facilitate new foreign capital inflow, or at least alleviate the rapid outflow of foreign capital, thereby stabilizing the exchange rate. Secondly, due to an increase in interest rates, domestic savings would also increase while consumption and investment would diminish, thereby improving the current account balance and stabilizing the exchange rate. Third, by taking a contractionary monetary stance to increase interest rates, inflation and exchange rates would simultaneously be lowered due to purchasing power parity (PPP).
Finally, under the
circumstances of continuous expectations of depreciation where speculative attacks were bound to persist, high interest rates would place a heavy burden on the cost of borrowing in domestic currency which would be used by speculators to purchase foreign currency, eventually curbing speculative demands in the foreign exchange market and stabilizing the exchange rate. This article makes an assessment as to whether the high interest rate policy was successful in preventing further capital outflow and achieving its goal of exchange rate stabilization. If the shift of the CID from positive to negative due to the high interest rate policy curbed capital outflows and attracted capital inflows, then we can judge that the policy was successful in stabilizing exchange rates. As seen in Chapter 3, the high interest rate policy was reflected in a corresponding change in the CID and not only did it improve rates of return on won-denominated assets, but it also made it profitable to invest in domestic assets by shifting the CID to a margin of 7% on average during January to March, 1998. Contrary to expectations, however, foreigners’ investment in domestic assets did not meet the changing circumstances, and the monthly net capital inflows recorded from December 1997 to March 1998 were –1.57 billion dollars, –0.86 billion dollars, 0.44 billion dollars, and 0.23 billion dollars, respectively. It is true that the net capital outflow in January, 1998, had actually slowed down in comparison with the previous month. Still, net capital outflow in January recorded 0.86 billion dollars despite the fact that the reversal of rates of return had been most significant at the time, and for the entire period from January to March, the net capital flow was still in the negative(0.19 billion dollars average momthly outflow). This proves that the reversal of rates of return induced by the high interest rate policy was unsuccessful in bringing about capital inflows. It also indicates that the high rates of return were not sufficient to offset the risks of sovereign default. In the meantime, most foreign financial institutions were still reluctant to allow any rollovers of loans extended to domestic financial institutions, and the high interest rate policy failed also to mitigate this situation of refusal to rollover. One important reason for this reluctance was that the creditors feared the loss of principal caused by sovereign default. In addition, the high interest rate policy did not affect the decisions of foreign financial institutions, since most credits to Korean financial institutions were denominated in dollars with interest rates of LIBOR plus
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additional spreads. Some can argue that the high interest rate policy was a decisive factor for a large amount of current account surplus and thus contributed to stabilizing the exchange rate. However, the huge current account surplus was not a result of the increase in exports, but rather a result of a rapid decrease in imports caused by domestic recession. Besides, allowing for the fact that the severe recession was a first-stage outcome of the high interest rate policy, the benefits of stabilizing the exchange rate should be weighed against the costs from this severe recession. The fact that the GDP growth rate for 1998 was –5.8%, a wide gap between the original prediction of –1.0% at the outbreak of the crisis, suggests further issues for consideration.
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VI. Summary and Conclusion An investor who chooses his investment, between an asset denominated in domestic currency and an asset denominated in foreign currency, will compare rates of return from these two assets. As for the asset denominated in foreign currency, the investor must also consider the exchange rate at the time of withdrawing his capital, and in order to hedge any risks arising from fluctuations in future exchange rates, he will agree on a future or forward contract. When there are no ‘barriers’ within these transactions, then the differentials in the rates of return will always be identical, or any discrepancy, at least, will be transitory. This is called a covered interest parity. Covered interest arbitrage means that the relative differential between the rates of return for two different assets denominated in their respective currencies represents the fundamental criteria for investment decisions of investors. The trend of deviation from covered interest parity observed during the Korean currency crisis reveals a different movement compared to the pre- and post- crisis period. In the pre-crisis period, the rate of return for won-denominated asset were higher than that for dollar-denominated assets by a margin of 1.7% on average. On the other hand, the phase of covered interest arbitrage during the crisis can be classified into three periods. First of all, during the period lasting from October 17 until December 14, 1997, the CID showed that it was more profitable to invest capital in dollar-denominated assets. It was mainly due to the widening gap between spot and forward exchange rates . During the period from December 15, 1997 to April 12, 1998, the trend of the CID was reversed and it became more profitable to invest in won-denominated assets. This reversal in the trend of the CID was mainly due to the diminishing gap between spot and forward exchange rate following the transition to a free-floating exchange rate regime, and the hike in the market interest rates after the adoption of the high interest rate policy. As foreign investors, however, were reluctant to engage in interest arbitrage for fear of sovereign default, the CID was allowed to stay in the negative persistently without much contributing capital inflow. Finally, during the period from April 13 to September 19, 1998, the trend of the CID once again reversed itself, making it more profitable to invest in dollar-denominated assets. This is attributable to widening gap between spot and forward exchange rates influenced by the rise in financial crisis in Eastern Europe and to continual lowering of interest rates by the Korean government. In the post–crisis period, CID steadily converged to zero. Aspects of self-fulfilling expectation in the Korean crisis for depreciation could be verified by the sharp increase in forward premium and the following crisis. Particularly, as foreign investors cast their doubts on Korea’s ability to acquire international liquidity after the
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bankruptcy of Kia, their expectations of depreciation aggravated further, precipitating a sharp hike in the forward exchange rates once again. The policy objective of the high interest rate policy at the time of the crisis was to prevent capital outflows by improving the rates of return at home. Nevertheless, this attempt proved futile, or at most limited, since it could not provide any explicit policy channels to prevent the refusal of foreign financial institutions to roll over credit, which was the largest component of the capital outflow. Moreover, this attempt failed to prevent further capital outflows in portfolio investment since it could not offset the foreign creditors’ perceived increase in country risk, or more specifically the risks of sovereign default in the crisis.
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