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Overview of Korea’s development experience

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Financial Policy

Foreign exchange liberalization

Following Korea’s liberation from Japanese colonial rule in 1945, the country adopted foreign exchange controls. Korea suffered from a shortage of foreign currency like most developing countries then. The exchange rate was fixed by agreement between Korean and U.S. governments. All transactions using foreign currency were strictly controlled by the government and limited only to authorized institutions.

Korea’s foreign exchange policy has varied with changing circumstances. The Korean government fixed its exchange rate to the U.S. dollar, subject to periodical readjustments, until 1980. After 16 years of a U.S. dollar-based currency peg, a multiple currency basket peg system was introduced in March 1980. In the late 1980s, Korea began to record huge trade surpluses and faced international pressure to shift toward a more flexible exchange rate system. The Korean government introduced the managed floating exchange rate regime in 1990. Since the won-dollar exchange rate under this system was determined in principle by market forces, the interbank foreign exchange market developed rapidly.

Foreign exchange market liberalization coincided with capital market liberalization in the 1980s. Significant opening measures were implemented through the 1990s. In January 1992, individual foreign investors were allowed to purchase domestic equities up to 3 percent of outstanding shares, but no more than 10 percent of a company’s shares in total were to be held by foreign investors. The government unveiled a blueprint in June 1993 for the liberalization and opening of the financial sector, aiming at substantial progress in financial market deregulation. Further capital account liberalization became inevitable when Korea joined the OECD in 1996. But Korea was reluctant to liberalize its capital account for fear of a dramatic increase in foreign capital inflows seeking high interest rates in the domestic market.

Most of the important liberalization measures were adopted under the IMF program in the aftermath of the 1997 financial crisis. In line with the IMF recommendations, the government agreed to undertake bold liberalization measures. The capital markets, including short-term money markets and the real estate markets, were opened completely to foreign investors. In December 1997, the government raised the ceiling on overall foreign ownership of stocks to 50 percent from the previous 26 percent. The individual foreign shareholder ceiling was raised from 7 percent to 50 percent. These ceilings were abolished completely on May 25, 1998. All regulations on the purchases of foreign debt securities were eliminated in December 1997. At the same time, all domestic enterprises, regardless of size, were allowed to borrow without limits from overseas, as long as the maturity did not exceed one year. All short-term money market instruments, including commercial papers and trade bills, also were fully liberalized on May 25, 1998.

The new system was implemented in two stages to allow sufficient time for improvements to be made in prudential, regulatory and accounting standards before full liberalization. The first stage of foreign exchange liberalization was implemented on April 1, 1999. The liberalization of restrictions on capital movements was accompanied by a relaxation of rules governing the use of foreign exchange. The Foreign Exchange Transactions Act replaced the Foreign Exchange Management Act in April 1999. In particular, it replaced the positive list system with a negative list system, allowing all capital account transactions except for those expressly forbidden by law. While foreign exchange dealings in the past were based on real demand, speculative forward transactions were permitted.

The first stage of the new system eliminated the one-year limit on foreign commercial loans while liberalizing various short-term capital transactions by corporations and financial institutions. Moreover, foreign exchange dealing was opened to all eligible financial institutions. The main components of the first phase of the foreign exchange liberalization program were as follows: First, regulations on capital account transactions were converted into a negative system, lifting all restrictions except for those limited by law or decrees. Second, regulations on foreign exchange institutions were revised. For instance, requirements for engaging in foreign exchange activities were changed from alicensing to a registration system, thereby liberalizing the establishment of money exchangers. Third, safeguard measures were established in the event of a sudden increase in either capital inflows or outflows or extremely unfavorable market conditions. The second stage of liberalization was implemented from January 2001. The notable features of the second phase of foreign exchange liberalization are as follows:

First, restrictions on the obligatory repatriation of external claims were eased to enhance the efficiency of overseas economic activities by both individuals and businesses, and to provide adequate ex post facto control measures.

Second, ceilings on overseas payments by residents were eliminated, including the 5,000 dollar per remittance ceiling on donation payments, the 10,000 dollar ceiling on overseas travel expenses; the 50,000 and 20,000 dollar ceilings on overseas stay and education expenses respectively; and the 1 million dollar ceiling on emigration expenses for a family of four. Instead, ex post facto control measures were introduced, including bank designation, automatic reporting to the National Tax Service, customs declarations, and prior notification to the Bank of Korea of large overseas payments.

Third, regulations and restrictions in many fields were abolished or eased. The major changes were: (1) The regulations on the purchase and sale of foreign exchanges were eased. (2) Restrictions were ended on won-denominated deposits or trusts with less than one-year maturity held by non-residents in domestic financial institutions. (3) The range of allowance for overseas borrowing and won lending was expanded. (4) OTC (over-the-counter) securities transactions between residents and non-residents were liberalized. (5) In addition to the liberalization of the purchase of overseas real estate properties by corporations and financial institutions for business purposes, residents were allowed to acquire overseas real estate for the purpose of establishing schools, hospitals or places of worship as long as the Bank of Korea were notified of the transactions and approved them. (6) Foreign exchange businesses were expanded. (7) Methods of corporate settlement were expanded. In May 2006, the Korean government accelerated the implementation schedule of foreign exchange liberalization to support its plans to create afinancial hub in Korea. This was seen as promoting the development of a more sophisticated foreign exchange market.

The balance between foreign exchange supply and demand in Korea should be achieved by means of relaxed regulations in the medium- to long-term. In the meantime, the need to complement and further develop the current foreign exchange liberalization plan has been raised in response to changes in economic conditions. The foreign exchange liberalization plan was revised and included the following components: (1) facilitating the won’s internationalization; (2) liberalizing foreign exchange transactions, including overseas investment by Korean citizens; and (3) improving the micro-structure of the foreign exchange market by easing regulations on foreign exchange positions and further stimulating autonomous market-making by market participants.

Source : SaKong, Il and Koh, Youngsun, 2010. The Korean Economy Six Decades of Growth and Development. Seoul: Korea Development Institute.