annually; in 1988, the won appreciated against the yen by 17.3 percent. In
1989 when Korea's current account surplus declined, the won appreciated
slightly against the dollar and continued to appreciate against the yen. On
balance between the end of 1985 and 1989, the won appreciated against the
dollar 31 percent in nominal terms and about 38 percent in real terms; against
the yen, the won depreciated about 6 percent in nominal terms and
appreciated about 8 percent in real terms. ³⁴

Capital controls were adjusted to encourage outward flow and reduce
the inward flow of capital. Perhaps the most important change in capital flows
was the prepayment of external debt. Prepayments totalled $16 billion or 27
percent of exports of goods and services in 1986-89. ³⁵ To reinforce this
effort, in 1986, the terms of foreign borrowing and domestic foreign-currency
borrowing were tightened. In 1987 and 1988, controls on the use of foreign
exchange for tourism and remittances were eased. ³⁶ In 1987-89, approval
procedures for overseas direct investments were simplified and tax benefits
for inward direct investment were reduced. In addition, approved Korean
firms were allowed to purchase foreign real estate and securities and retain
more foreign exchange earnings overseas.

Trade liberalization also contributed to monetary and price stability.
Trade liberalization often targeted scarce products to help reduce domestic
prices. Tariff reductions or less binding quotas had the immediate effect of
reducing the price of imported goods, as well as the intermediate effect of
reducing the trade surplus, the source of monetary expansion and therefore
of inflationary pressure in the first place.

The Korean government took many steps to relieve the potential
inflationary consequences of the large balance of payments surplus that
developed in the second half of the 1980s. As a short-run response, the
government greatly expanded its use of reserve asset management to help
sterilize its foreign exchange intervention. As a longer-term solution, the
government made changes in its exchange rate policy, capital controls, and
trade policy to reduce the balance of payments surplus. The measures
included steps toward liberalizing Korea's domestic interest rates, system of
allocating domestic credit, and exchange rate and capital control systems.
However, some of the measures to offset the balance of payments surplus
involved additional tightening of existing controls (primarily on capital
inflows). In addition, while these steps were extensive, they were not entirely
effective, as evidenced by the subsequent acceleration of consumer price and
asset price inflation.

Unfortunately, it appears that many of these steps toward liberalization
were taken to meet more limited objectives--like reducing the inflationary
impact of the balance of payments surplus ³⁷ --rather than as a comprehen-

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