Academic journal article Asian Development Review

Are Capital Controls Effective? the Case of the Republic of Korea

Academic journal article Asian Development Review

Are Capital Controls Effective? the Case of the Republic of Korea

Article excerpt

Capital controls have recently attracted interest as capital surges in emerging market economies threaten to bring about economic instability and heighten difficulties in implementing macroeconomic policies. While an option that can be taken to deal with huge capital inflows involves the use of capital controls, there is no consensus on their effectiveness. Against this background, our paper aims to investigate the effectiveness of capital controls in the Republic of Korea. This paper first reviews the history of capital account policy, which can be divided into five stages: (i) gradual liberalization during the 1980s and early 1990s, (ii) acceleration of liberalization during the early and mid-1990s, (iii) the big-bang approach to liberalization during the Asian financial crisis, (iv) liberalization for facilitation of capital market development beginning the late 1990s, and (v) the conservative approach during the global financial crisis. To quantify the trends, this paper constructs measures of capital account control/liberalization based on the official record of government policies. In the second part, it discusses the effects of capital account control/liberalization in four ways. First, the behavior of key macro variables in the Republic of Korea is reviewed by comparing the periods before and after serious capital account liberalization. Second, the effects of shocks to the capital account control/liberalization indexes on capital flows are examined using a VAR model. Third, the effects of the United States (US) monetary policy shocks on capital flows and the interest rate of the Republic of Korea are examined for the period of capital controls and the period of capital account liberalization. Fourth, a simple event study is conducted of recent capital control measures. The empirical results based on VAR models show that shocks to capital account controls do not have significant effects on capital flows in most cases. However, capital flows, the current account, and the exchange rate were far more volatile in the period of a liberalized capital account. It is also interesting that during the latter period, the Republic of Korea did not gain monetary autonomy despite adopting a freely floating exchange rate. This result may be related to volatile capital flows under a liberalized capital account. Finally, the results of the event study tend to support the effectiveness of capital controls in altering the composition of capital flows.

JEL classification: F3

(ProQuest: ... denotes formulae omitted.)


The influx of capital inflows has been one of the more difficult problems of emerging market economies. Such economies suffer from rapid capital inflows and outflows, generating boom-bust cycles. In the initial period of capital surges, one finds real exchange rate appreciation, domestic credit expansion, consumption and investment booms, and asset price bubbles. Over time, however, the process tends to reverse itself - real exchange rate appreciation worsens the international competitiveness of firms and brings about a current account deficit, influencing foreign investors to lower their view on the domestic market and withdraw capital investment. Therefore, net capital inflows turn into capital outflows, which end the boom phase and start the bust phase. The economy may eventually collapse.

Even if no such dramatic cycles are found, volatile capital flows are likely to increase the volatility of the economy. Volatile capital flows tend to increase the volatility of the exchange rate, liquidity, and asset prices. This makes it hard for policymakers to implement monetary and exchange rate policy to mitigate the negative effects of capital inflows on the economy.

Capital controls are a common tool for mitigating the negative effects of capital inflows in emerging market economies. While these can take a variety of forms, for countries that have substantially liberalized the capital account, more market-based controls (such as a tax on inflows) have been the predominant option in recent years. …

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