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Financial deregulation and segmented capital markets: The case of Korea
LCor[tl Drlelopnlmr, Vol. 16. $0. Printed m Great Britam
I. pp. ISS-194.
0305-7%?c/SS
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0
Financial Deregulation and Segmented Markets: The Case of Korea SEBASTIAN University
53.00 + 0.00
19SY Pergamon Press plc
Capital
EDWARDS*
of Cdifortria,
Los
Angeles
Summary. - This paper deals with the relation hetuern the official and the unregulated (or curb) segments of the capital market in Korea. The pupcr focuses on the behavior of officially controlled interest rates paid on time dcpohits and on freely determined curb market interest rates. The effects of financial deregulation on intrrcst rates. Investment and growth are investigated. It is argued that under some (plausible) circumstances financial deregulation can prnrratc significant crowding out in the curb market. reducing the total deyrec of financial intermediation. The empirical results provide some support to the crowding-out hypothesis, and indicate that changes in the officially controlled time deposit rate have bwn positively related to changes in the ~~Orcgatcinvestment function is also estimated freely determined curb market intcrcst rate. An a,, for Korea. It is found that an increase (dccrcase) in the curb rate discourascs (encourages) invcstmcnt; on the other hand, incrcabes in the real volume of credit intermediate in the official scgment have a positive effect on real a~~rcgate inw’rtment.
credit
allocation. The no-market clearing interest rates were reflected on the continued importance of the unofficial or curb fitrcrt~cid markrt.’ In fact, the segmented nature of the Korean financial market - where this curb segment coexists kvith the official financial institutions makes the analysis of the possible effects of financial policies particularly interesting and difficult. For example. under capital market segmentation it is possible that the liberalization of the official segment will result in a reduction of the overall degree of intermediation. This would be the case. for example. if as a result of the reform the degree of intermediation crowded out in the curb market exceeded the increase in intermediation in the official segment. In this paper I analyze the interaction between the official and curb capital markets in Korea. The paper focuses on the relation between official interest rates on time deposits in the control-
1. INTRODUCTION In lYS1, Korea’s Fifth Five Year Plan established as one of its goals the liberalization of the country’s financial sector. In the following years a number of steps towards reforming the capital market were actually taken. The main characteristics of these reforms were: (a) new financial instruments were created: (b) some measures geared at increasin_r competition among banks were implemented, Including the privatization of commercial banks, and the granting of permission to foreign banks to participate in a number of areas previously restricted to domestic banks; (c) banks were allowed to increase the scope of their business beyond intermediating time deposits: (d) overall competition in the financial sector was encouraged by giving a more important role to non-bank financial institutions; (e) explicit government intervention in the allocation of credit was reduced; and (f) a somewhat greater degree of flexibility in terms of the interest rate which banks could charge on their loans was allowed. ’ In spite of these important steps towards deregulating the financial sector, by late 1986 a number of controls were still in place. Particularly important among them were the fixing of interest rates at non-clearing levels, and government’s implicit interference in the process of
‘This paper draws on a report written for the World Bank in February 1986. Discussions with Farrukh Iqbal have been very helpful. Danny Leipziger. S. Y. Kwack and Tony Chan provided very helpful comments. The views presented here are those of the author. and do not necessarily reflect those of the World Bank. This research has been supported by National Science Foundation Grant # S-l 19931.
I85
IS6
M’ORLD
DE\‘ELOPhfENT
led segment. and freely determined interest rates in the curb market. and discusses the probable effects on interest rates. intermediation. and investment. of policies aimed at further dereguluting the Korean financial market. This analysis is particularly relevant since it is expected that during the next few years Korea will undertake steps towards further “liberalizing” its financial sector, by raising interest rate‘s paid on time deposits and rehising some of the esibting controls on international capital llovvs. The paper is organized in the following form: Section 1 is the introduction. In Section 2 some important implications of financial liberalization policies in a segmented capital market setting are briefly discussed. In Section 3 the historical behavior of official and freely determined interest rates in Korea is briefly presented. In section -I a model of interest rates determination in a semiopen economy is developed and used to analyze the behavior of Korea’s curb market interest rates. It is found that freely determined (curb) interest rates have responded to a number of variables, including changes in overall domestic liquidity. expectations of devaluation. world interest rates. and official interest rates paid on time deposits in the controlled segment. In Section 5 an investment function is estimated for Korea. The results obtained show that the investment ratio has been negatively related to the curb market real interest rate, and positively related to the real availability of credit in the official segment. Finally, Section 6 contains the concluding including some implications of the remarks, empirical analysis.
7. FINANCIAL LIBERALIZATION. INTEREST RATES. SEGMENTATION ECONOhIIC ACTIVITY
AND
official segment or curb market.’ XI a result of this. total intr’rmedlatic~n may actually decline. rather than increase. as the conventional vie\\ suggests. van \i’ijnbrrgen ( l%4b) developed a formal portfolio model of a financially “repressed” economy to analyze theoretically the effects of a financial reform in a country with a segmented capital market. The capital market consists of two segments: the official banking sector, vvhich is subject to government regulation and interest rate controls. and the informal or curb segment. where interest rates are freely determined. In this model households can allocate their wealth across three assets: (1) currency: (2) time deposits in the official banking sector: and (3) loans in the informat curb market. It is assumed that all three assets are gross substitutes. so that an increase in the return in one asset reduces the amount demanded of the other two. In this model the official banking sector is subject to a positive. and relatively high, legal reserve requirement.’ In the curb market, however. there is “direct intermewith a one-to-one relation between “dediation.” posits” and loans. The demand for loans comes from firms. Naturally, since interest rates charged by banks in the official segment are below market level - that is. after all. the definition of financial repression firms are eager to get as much funds as possible at this lower rate. Equilibrium in the curb market is established when the supply of loans to this segment SCurh( ) is equal to the demand for this type of loans. This demand, in turn is equal to the firm’s total demand for loans DT( ) ~?~in~s the banks’ supply of loans in the official segment. SnanLr( ), Since in the official segment there is a reserve requirement CL, banks can only lend a fraction (l-u) of their time deposits (this ignores free reserves). Equilibrium in the curb market can then be written as: Scurh( ) = Dr(
According to the more traditional financial repression view of Shaw (1973) and McKinnon (1973). in a country with rudimentary capital markets a financial reform that raises interest rates paid on time deposits will increase savings, increase investment and ultimately result in higher growth.’ Central to this analysis is the idea that by reforming the financial sector, funds will flow from unproductive uses, such as real estate speculation, gold, or foreign exchange holdings, into the formal financial system, with the subsequent increase in net intermediation. Recently, however, it has been argued that in countries with a large informal financial market. \uch as Korea, the liberalization of interest rates in the official segment will croi~ri OUTfunds from the un-
) _ SnallL\( ),
(1)
In this simple setting, an administrative increase of the interest rate paid on time deposits in the controlled sepment will have two interrelated effects. First, asset holders will reshuffle their portfolios, moving away from both loans to the curb market and from currency, and into time deposits. That means that SCurh( ). in equation (1). will go down. Second, as a direct consequence of the increase in the volume of time deposits, the bank will be able to increase their loans to firms - SB’““( ) will increase. However, since in the official segment reserve requirements are positive (and relativelv high). bank loans will only increase by a fraction (l-u) of the increase in time deposits.
FINANCIAL
What will happen to interest rates in the curb segment? They can increase or decrease. depending on the degree of substitutability of time drposits and curb loans in the private sector portfolios. and on the rate of reserve requirements of deposit money banks. If time deposits and curb loans are very close substitutes. most of the increased volume of time deposits following the increase in official interest rates will come from lower curb loans. In terms of equation (1) .Scurh( ) will experience an important decline. If. in addition. banks’ reserve requirements are high. the banks’ supply for loans will increase by a relatively small amount. As a result of this, interest rates in the curb sector will probably increase, with total intermediation declining. If. on the other hand. time deposits are very close substitutes with currency. interest rates in the curb sector will tend to decline, and total financial intermediation will increase. as suggested by the conventional view. In this case, most of the increased volume of time deposits following the increase in official interest rates will come from lower holdings of currency. It follows from the above discussion that whether in a particular case the financial liberalization reform will work in the traditional way. increasing the total volume of financial intermediation, or in the fashion suggested by the reform critics is an empirical matter. Unfortunately it is a difficult empirical question. since many of the required data to perform the analysis and especially those pertaining to the informal curb market many times are not available. Although in almost every case there are no data on the volume of intermediation that takes place in the informal or curb market, there are some indirect ways of analyzing the effects of a liberalization reform on the curb market. More specifically. if there are data on curb interest rates. it is possible to indirectly test the crowding out hypothesis, by analyzing the effects of changes in interest rates paid on time deposits on curb market interest rates. From an empirical point of view. then, an indirect test of the crowding out hypothesis would consist of estimating whether, with other things given, a higher interest rate paid on time deposits in the official market results in an increase in the curb market interest rate. Sections 3 and 4 are. in fact. devoted to an empirical analysis of this type for the case of Korea.
3. OFFICIAL INTEREST Table
AND CURB MARKET RATES IN KOREA
1 contains data on different
interest
rates
157
DEREGL’LATION
Table
1. Interest rues in Korea tirrtuj
197745
(quurterly
Reid Time
Nominal
YKlr and quarter
Curb rate
deposir
1977:3 lY77:1
35.5 a-r.0
16.2 l-t.3
15.0 15.0
21.8 30.5
75 1;:x
I.3 11.5
197s: 1 197s:z lY7S:3 lY7S:J
3S.1 3s.-J 43.2 46.S
14.4 1S.O IX.6 IS.6
15.0 Ii.0 IS.0 18.5
14.1 26.0 23.9 35.3
-Y.Y 5.6 -0.7 7.1
-9.3 2.6 - I.3 7.0
197’): I 1979:’ lY7Y:3 lY7Y:J
44.0 42.0 40.7 42.7
18.6 18.6 18.6 18.6
19.1 19.0 19.0 19.0
25.s 9.0 29.0 27.5
0.4 -14.5 6.9 3.4
0.9 -14.1 .7.3 3.x
IYXO:I 1980:2 19so:i 19so:1
5O.Y 4.x 42.5 37.7
23.3 ‘4.0 22.9 21.4
24.3 1-1.7 23.7 1O.S
1.1 11.3 21.6 4.5
-23.4 - 10.5 1.0 -11.8
-12.4 -Y.S 2.8 -17.4
1YYI:l lYS1:2 19SI:3 1981:-i
36.6 35.2 33.Y 35.4
IY.5 IY.5 19.5 19.0
20.0 20.0 20.0 lY.O
19.5 15.7 12,s 32.7
2.4 0.0 -1.5 16.3
2.0 0.5 - I.0 16.3
1981: I 1982:2 19x7:3 19S’:J
32.6 33.1 27.5 79.0
15.1 12.5 8.0 8.0
16.1 13.Y 10.0 10.0
27.8 26.3 21.3 2S.1
10.3 5.7 1.8 7.1
11.3 7.1 4.S 9.4
lYS3: I 19s3:2 1983:3 19s3:1
24.1 27.5 26.8 24.7
S.0 8.0 8.0 8.0
10.0 10.0 10.0 10.0
16.3 26.1 26.2 24.7
0.z 6.6 7.1 s.0
2.2 8.6 9.1 10.0
lYS-1: 1 198-t:? 1984:3 19s4:1
21.1 25.7 23.5 B.-l
10.0 10.0 10.0 10.0
10.1 10.5 IO.5 11.1
18.2 23.5 22.1 24.2
4. I 7.8 S.6 8.8
4.5 8.3 9.1 9.9
19S5: 1 19Sj:Z
27.7 27.0
10.0 10.0
11.5 Il.5
21.2 Z-l.1
6.5 7.1
S.0 8.6
Source:
Bank
Time rate
Loan Curb rate rate
deposit
rate
Loan rate
of Korea.
in Korea for 1977-85. The real rates have been computed using the annualized rate of inflation for the corresponding quarter. As may be seen. until 1951 there was a profusion of negative real rates. However. starting with that year - and as a result of the measures undertaken as part of the Fifth Five Year Plan - all interest rates included in the sample have been consistently positive. Moreover. between 1984 and 19% real rates, both in the official and controlled financial seg-
I xs
N’ORLD
DEb’ELOPhIEYT
bvere quite high. Fur esample. during IYSS the real interest rate on loans in the official market averaged approsim:ttf2l~ Y’!,, per qr;lr. The correspondins real rate on time deposlth in the commercial hanks a\eragrd Amost S”,, per annum. In spite of this sharp incrtxw in real wtes in the official market and of the addition~~l tleuibility introduced by the Fifth Plan on Icndin~ r:ttcb which allowed banks to charpe anything between lO’:i, 2nd I I.5’!’ o - in late IYSS there \vere still indications that a situation of escess demand for funcls persisted in the official segment. Thi$ escess demand was retlected in two basic M’;I~s. First, as indicated above. the curb market activities continued to be bery important and the interest rate differential between the organized and unorganized segments rscrrds anq ~~re:tsonable” risk premium. Second. there iv;15 aidence sug
Figure I depicts the behavior of the official nominal interat rate paid on time &posit>. the curb nominal rate. and the US Treasury bill ratr‘. which is used LIP ;I prosy for world interest rata. As can be seen the spr& between the freeI> &termined curb rate and the other two interat rates have been Ggnificant and perhibtent. It is particularly interesting to note that throughout the period the spread between the curb rate and the US Treasury bill exceeds. by ;I wbbtantial margin, any reasonable estimate of the expected rate of devaluation of the u.on.h Also. notice that in the more recent period the officially pegped time deposit rate has mobed closely with the US T-bill rate. As ;I preliminary step in the analysis of interat rate behavror rn the unottrcr;ll sector some regressions relating the curb market rate and the officially fixed time deposit rate were estimated. The regressions used both yearly data for IYW-S-I and quarterly data for 1977-M. The yearI> regression using ordinary least squares (OLS) bieldrd the following result. where the number in parentheses are t-statistics: Curb =
0.169 (7.605)
+
0.146 (112YZ)
TDK
Ii’ = O.YOl D.VV’. = 2.087 (2)
The quarterly regression KIS estimatai ordinary least squares corrected by first
using order
FINANCIAL serial correlation. lY77-X5 only. Curb
=
0.167 (-l.-t-h))
and used data
+
for
I. IS0 TDR R’ D.iV. (5.17-I)
DEREGCLXTION
the period
= O.-ISY = l.S-I7(3)
IXY
of devaluation. In Edwards (1YS.i) I have argued that interest rate behavior in a small semi-open economy can be captured by the following equation:’
Ai, = O[(iW, + D, + P,) - i,-,] - k[log L,_, As many be seen in both cases the coefficient of the time deposit rate is positive and significant. some preliminary support to the providing hypothesis that during these periods administered increases in the time deposit rate in the official market provoked crowding out in the financial market. Of course. a problem with these regressions is that they ignore the possible intluence of other variables in the determination of the curb market interest rate. In the section that follows a more complete model of interest rate behavior in the free (curb) market. that incorporates the role of foreign variables as well as domestic liquidity is estimated to further analyze this issue.
1. A MODEL OF INTEREST RATE DETERMINATION IN KOREA The regressions above [equations (2) and (3)] showed that there has been a significantly positive relation between officially fixed nominal interest rates and the freely determined interest rates in the unofficial or curb market. However, in order to fully understand the behavior of interest rates in the free segment it is necessary to have a more complete model of interest rate behavior. In particular. one would like to have some idea on how the interest rates react (if at all) to changes in world interest rates. changes in the expected rate of devaluation, and to changes in domestic monetary and credit policies. Most empirical studies on interest rate behavior have made extreme assumptions regarding the degree of openness of the economy. It has been generally assumed that the country m question is either completely closed to the rest of the world or that it is fully open and that there are no capital controls. These extreme assumptions are. of course, inadequate for middle-income countries such as Korea, where the degree of openness corresponds to some intermediate situation. The capital account is partially open and there are some controls to capital movements.’ Presumably in a semi-open economy with some legal restrictions to capital movements - interest rates will be affected in the short to medium run by both closed economy factors, like the situation of excess demand or supply for total real liquidity in the economy, and open economy conditions such as world interest rates and the expected rate
- 10s L:’ ]
(-I)
where i is the domestic nominal interest rate for a particular financial instrument; iW is the world interest rate for instruments of the same characteristic as the domestic ones (with the exception of currency of denomination); D is the expected rate of devaluation: P is a risk premium factor; ,!. is a measure of real liquidity in the economy (i.e.. broadly defined money or domestic credit. for example); and L” is the real quantity of this liquidity aggregate desired by the public (I.e.. the real demand for money or domestic credit). This equation combines open and closed economy factors as possible determinants of the domesttc interest rate. and lets the data reveal what is the actual degree of economic (as opposed to legal) openness of the economy. The first term in equation (-I) captures the open economy factors affecting domestic interest rates. It states that there will be some forces in the economy that uill cause interest rates to move (slowly) through time in the direction sugpested by the uncovered interest parity. The speed and extent at which that movement will take place will depend on the parameter 0. The second term of this equation refers to the closed economy factors affecting the interest rate in the short run, in this small open economy. It states that, with other things given. an excess supply for real liquidity (i.e., money) will exercise a downward pressure on the domestic interest rate. An important property of equation (4) is that the extreme situations of fully open or completely closed economies are particular cases. If the economy under study is completely open to capital movements. we would expect that 0 = 1 arrd ii = 0. In that case equation (4) becomes an interest arbitrage condition, where the domestic interest rate is equal to the world interest rate plus expected devaluation and risk premium. If, on the other hand, the economy is completely closed to foreign influences. it would be expected that 0 = 0 and k 2 0: the domestic interest rate will depend only on domestic monetary factors. Intermediate cases of semi-open (semi-closed) economy will have positive 8 and J.. Notice that according to equation (3). in the long run of the semi-open case there will be monetary equilibrium (log L = log ,“I. and the domestic nominal interest rate will depend on open economy factors only. However. because of the existence of a
WORLD
190
DEVELOPblENT
risk premium term P,. even in the long run the domestic nominal interest rate can (and usually will) differ from that world rate plus expected devaluation. One of the most attractive features of this model is that it allows the data to reveal vvhether a country is financially “open” or ‘-closed.” In fact. this model allows for discrepancies between the legal and the economic degrees of --openness.” In order to empirically estimate (-I) it is first necessary to specify the demand for real liquidity function L”. Following Edwards (1985) and Edwards and Khan (1985) we consider a semilogarithmic demand for real money function: log L’f = b,, + b, logy, - 62 i,
(5)
where y is real income, and where bi and 62 are positive parameters. Combining this demand for L equation with the interest rate equation (-1) presented above, the following reduced form for interest rate determination in semi-open economies, can be obtained (where E, is an error term with the usual properties): i, = PO + @,(iCV, + D, + P,) + &i,-, + p, log 172,_, + p_Ilogy, + E,. The l3 coefficients tural parameters PI=
p3=
in (6) are related to the strucin the following way: p_ =
8 (l+hb?)
’
-I
:
(l+hb,)
(6)
’ p4 =
(I-e)
(l+hbz)
;
hbl (l+hb?)
Equation (6) refers to the determination of the market, freely determined nominal interest rate. In that regard, within the Korean framework. i has to be interpreted as the curb market interest rate. A problem with this equation, however, is that it does not incorporate in any way the fact that in Korea there is a segmented capital market where the official (controlled) and the unofficial markets coexist. In order to capture this segmentation, and more specifically the possible effect of changes in the administratively determined term deposit rate on the curb interest rate, an additional term (l3s TDR,) can be added to equation (6). where as before TDR stands for time deposit rate. Modified equation (6) - which adds the official time deposit rate - will then allow us to know how “financial liberalization policies” (i.e., policies that raise TDR), as well as exogenous shocks, have affected the freely determined interest rate in Korea. The reduced form equation
to be estimated is the following (where u is an error term assumed to have the usual properties): i, = fir, + B,(iLV, + D, + P,) + \32i,_, + 13:log L,_ , + fi1 lay y, + fis TDR, + lt,
(7)
where it is expected that fii > 0. l& > 0. l3; < 0. l& > 0. The coefficient of TDR can be positive or negative. A negative & will indicate that the results of the conventional model have prevailed in Korea. A positive pi. on the other hand, will be a reflection of the relevance of the alternative portfolio model with close substitutability between time deposits and curb loans. If the crowdin.g, out hypothesis is true. and increase in the otficially determined rate will, with other things given, result in higher interest rates in the free segment. and we will find that p5 > 0. In the estimation of equation (7) some decisions have to be made in terms of the data actually used. i is the curb market rate as collected by the Bank of Korea (see Table 1). iW is the US Treasury bills rate. In some regressions not reported here, however. the LIBOR rate was used instead. with no effects on the results. The definition of D,, the expected rate of devaluation. is particularly difficult. In this paper it was proxied by the actual rate of devaluation. This simplifying assumption. which is consistent with the perfect foresight variant of the rational expectations view. is not unreasonable for Korea in the recent period since. starting in early 1980 the won has been following a fairly slow moving rate of crawl.” With respect to the risk premium term it was assumed that it was equal to a constant plus a random term with the usual characteristics. y is real GDP as computed by the Bank of Korea. Two alternative variables were used as proxies of real liquidity. The first was domestic credit (denoted by DC) and the second total debts of the banking sector (denoted by Db). The time series for both of these variables were obtained from the International Financial Statistics. In other regressions not reported here M2 was used. without affecting the results. Before estimating equation (7) it is also necessary to make a judgment regarding the exogeneity of the time deposit rate. If the monetary authorities determine TDR based on criteria that are unrelated to the behavior of the curb market interest rate, it is legitimate to consider TDR as exogenous, and to estimate (7) using ordinary least squares. If, on the other hand, in order to determine the official TDR the monetary authorities follow a feedback rule that takes into account the behavior of the curb rate in the same period. equation (7) should be estimated using instrumental variables. Since there is no indica-
FINANCIAL
tion that the Korean monetary authorities have actually considered the behavior of the curb rate when altering the level of TDR. in this paper equation (7) was estimated using OLS.“’ Table 2 contains the results obtained from the estimation of equation (7) for interest rate determination using ordinary least squares on quarterly data. Equation (7.1) was estimated using real domestic credit (DC) as the relevant real liquidity variable, whereas in equation (7.2). total real bank debt (Db) was used as the liquidity variable. The results are quite satisfactory. First, all the coefficients have the expected signs. Second, with the exception of y in both regressions, all of them are significant at either the 5 or 10% levels. It is interesting to note that the estimated values (point estimates) of some of the coefficients are quite low. suggesting that on average the curb market interest rate may have reacted with some sluggishness to different types
Table
2. Nornitd
rernlinnriorl qttnrterly
irlteresr rule tlein Korea, 1978-S: data (ordirwry lecrst squcwes)
Eq.
(7.1)
Eq.
(7.2)
constant
0.47-I (1.769)*
0.4 I (1.560)
(iW,
O.OSI (1.977)
0.076 (1.710)
0.47-l (3.013)
OS-13 (3.423)
L
+ D,)
I
log
DC,_,
log
Db,_,
-0.081 (-2.661) -
-
0.049 (-2.112)
1% .v,
0.076 (0.276)
0.024 (0.858)
TDR
0.371 ( 1.974)
0.290 (1.800)
ri’t
0.841
0.873
D.W.;
1.83
1.50
‘The numbers in parentheses are tstatistics. tI?’ is the coefficient of determination corrected by degrees of freedom. tD.W. is the Durbin-Watson statistic.
I91
DEREGULATION
of shocks. Broadly speaking, the result in Table 2 indicate that the freely determined curb interest rate in Korea has reacted both to closed and open economy factors. More specifically. freely determined (curb) interest rates have responded to (a) changes in the expected rate of devaluation and in the world interest rate; (b) changes in the conditions of real liquidity in the economy; and (c) changes in the officially controlled time deposit rate. The estimates of the coefficient B in Table 2 indicate that with other things given, an increase in the officially administered time deposit rate of one percentage point have been reflected in an increase in the freely determined curb market rate of approximately 0.4-0.3 percentage points (30-40 basis points). Notice that the coefficients of TDR in equations (7.1) and (7.2) are significantly smaller than the estimate obtained in equation (3), indicating that ignoring other variables [as in (3)] can result in significant bias and misleading results. From the empirical results in Table 2 it is possible to calculate the coefficients 0 and h in equation (6). These coefficients provide information on how fast a particular disequilibrium is transmitted into domestic interest rates. For example from regression (7.1) it is obtained that 8 = 0.15 and k = 0.16. In terms of the influence of open economy factors, this means that an increase in the expected rate of devaluation, or of world rates of interest, of 10 percentage points will be translated into a higher curb market nominal rate of little less than one percentage point during the same quarter. After six quarters the curb rate would have increased by approximately four percentage points. In that regard, these results show that Korea is in fact a semi-open economy;where open economy factors have a non-negligible influence on interest rates behavior.
5. CURB FINANCIAL MARKET, SEGMENT, AND INVESTMENT
OFFICIAL IN KOREA
In the preceding section it was empirically established that. with other things given, increases in the official rate have historically resulted in higher curb market interest rates. What still has to be investigated is how increases in time deposit rates have affected investment. This can be analyzed by estimating an equation that incorporates the potential roles of both the curb and official segments of the capital markets on funds availabihty and investment. Once more, however, there are data problems. First, as already noted, there are no data on the volume of intermediation in the curb market. Second, there are no data on the virtual interest rates that clear
192
WORLD
DE\‘ELOPXIENT
the rationed official markt. For this reason ;I compromised investment function has to he estimated using the available data. In the present studv the following equation was considered.” INVR,
= ‘{,) + *i, INVR,_,
+ ‘/; DLOAN,_,
+ yz CURBR,_,
+ *~,(_Y,-,--).~-~)
+ +,
(S)
where INVR is real aggregate investment, CURBR is the curb market red interest rate. DLOAN is the rcwl flow of news loans in the official financial sector. and (?,,-I-y,-2) is an accelerator term. withy being real output. Under the hypothesis that both the official and curb markets affect investment. it is expected that the coefficient of CURBR would be sipnificantly negative. indicating that a higher real interest rate in the free segment discourages investment, while that of DLOAN would be significantly positive. This is because a hipher value of DLOAN reflects a higher degree of intermediation via commercial banks. and thus availability of funds. in the official segment of the capital market. In order to take into account possible problems stemming from the error in measuring the rcctl curb market interest rate. xi instrumental variables estimator was used. DLOAN was constructed using data on total real IWIIS. with the raw data being taken from the IMF /~r/crr~rrriortn/ Fi~rtrr~cirrl Strrtisrics. Since in preliminary fits the residuals from (S) exhibited negative sertal correlation. the estimation was performed usins Fair’s method for correcting instrumental variables estimates for first order autocorrelation. The estimation of (8) using annual data for 196%S3 yielded the following result where the numbers in purentheses are r-statistics.” 22.927 (2.920)
+
0.752 (17.S57)
INVR(-
1)
0.490 [v( - l)-y(-2)] (3.361) O.S-IS (-3.705) + 1.907 (5.398)
CURBR(-
1)
DLOAN Rho = -0.68
(9)
These results. then, provide statistical support to the hypothesis that real investment behavior has been influenced by developments in both the official and curb segments of the capital market. These estimates are in line with van Wijnbergen (1984,). who used a similar specification to estimate a private sector function and also found that both loans and the curb real rate were
important.
Other studies. however. have been in identifying the importance of both elements in the determination of investment. For esample in his estimates for nonhousing private investment. Cheons ( 1983) obtained a significantly positive real liquidity term. and an insignificantly negative coefficient for the real curb market rate. Knack (1985) did not incorporate the curb market interest rate in his investment function. It‘s> successful
6. CONCLUDING
REMARKS
This paper has dealt with the effects of financial liberalization in the presence of a setemented capital market. as in the case of Korea. It was pointed out that under the type of institutional arrangement prevailing in Korea a financial reform that raises interest rates in the official segment is likely to crowd out funds that were previously intermediated by the curb market. Whether as a result of the reform tolc11intermediation (in the official and curb segments) will increase of decrease will depend on a number of variables. including reserve requirements in the official segment. optimal precautionary reserves in the curb market. and various elasticities. An empirical model of interest rate detrrmination in a small economy with capital controls was estimated. It was found that nominal curb market interest rates in Korea have basicall> responded to three forces: (a) the evolution of real liquidity in the economy; (b) open economy factors. such as world interest rates and espected dev~aluation: and (c) officially fixed interest rates in the orpanized segment. With respect to this last factor it was found that, with other things given. higher (lower) official rates paid on timct deposits have resulted in higher (lower) curb market rates. This positive relation beween the time deposit and curb market nominal interest rates provides some support for the crowding out hypothesis. An aggregate investment function was estimated in order to have an idea of how financial reform has affected capital accumulation. Both the change in the total level of real domestic credit in the official segment and in the curb real interest rate were included as independent variables. The results obtained show that both of these variables have influenced the behavior of aggregate real investment in Korea. Hisher curb rates discourage investment. while faster growth of real credit in the official segment encourages investment. By now most economists accept that it is difficult if not outright incorrect to use estimated equations based on historical data to
FINANCIAL
IY.3
DEREGULATION
(mechanically) forecast the future.” In our case. however. we can use the information obtained from the estimation of the interest rate and investment equations to tiiscltss the possible evolution of some critical variables in Korea in the years to come. First. to the extent that. as is anticipated. Korea embarks on more ambitious financial reforms. we will observe structural changes in equation (7) on nominal interest rate behavior in the free (curb) market sector. For example, the relaxation of existing controls to international capital movements will possibly result in an increase in parameter 8 and in a decline in 1. This means that freely determined domestic interest rates will possibly move more closely with world interest rates. This, of course. is nothing else than a reflection of the fact that in economies that have a more open capital account the authorities’ ability to influence interest rates (even in the short run) is greatly reduced. In a way. then, a higher degree of financial openness to the rest of the world will very likely reduce the monetary authorities’ ability to intluence some key macroeconomic variables. A greater degree of openness of the capital account will also have important consequences for the interaction between exchange rate policies and the domestic financial sector. The higher is 0. the more quickly will expected changes in the exchange rate be translated into htpher domestic interest rates. This suggests that in the future there will be some trade-offs related to a
more active manipulation of the nominal exchange rate. if Korea pursues the publicized goal of putting an end to the reliance on foreign savings, a more active eschange rate policy geared at penerating real devaluations will probably be implemented. If this means that there will be a faster rate of crawl of the nominal exchange rate. we will likely observe higher domestic nominal (and real) curb interest rates. which in turn will be translated into lower aggregate investment (recall the estimates in equation (S)). The results from equation (S) suggest that increase in the time deposit interest rates have exercised two kinds of forces on investment. Notice. however, that as the ‘-financial reform” continues, we possibly will also observe important structural changes in this equation. In particular as the importance and coverage of the curb market declines with the liberalization. so will the coefficient of CURBR in (S). In the limit. of course, the curb segment will disappear all transactions will take place in the free “official” segment and CURBR will cease to be a relevant variable in the investment equation. Notice however, that if Korea maintains its traditional prudent approach to economic reform. this process of structural decline in the importance of CURBR in the investment equation will take some time, and we can espect that in the next few years the developments in both the official and unofficial segments will continue to influence real investment.
NOTES I, On the recent evolution of Korea’s financial seetor see Park (1976. 1YS.i): World Bank (lYX7): Cho (1985); and Kim (I’M). 2. There are some indications. however. that during the last few years the size of the unofficial or curb market has declined. For example. a survey performed hy the Citizen National Bank indicates that betvvcen IYt(0 and 1983 households have steadily decreased the fraction of their savings channeled through the curb market from 70.2% of total savings to 3Y.2% (see World Bank. 1987). 3. According to this approach the initial conditions are characterized bv artificially low nominal rates. which usually result in negative recll interest rates. See Shaw (1973) and McKinnon (IY73). 1. See. for example. (198Ja. 19Ylb). 5. Although the Korea is only 4.5%. dential factors would ratio if liberalization
Buffir
(1981):
van Wijnbergen
current reserve requirement in it may well be expected that prulead to an increase in the reserve achieves one of its objcctivcs ol
freeing banks from government involvement. At present, that ratio is non-opcrativc in an\ real \cn\c ~3 loans exceed deposits hy as much as 21l”,, financed by the Bank of Korea. With geater autonomy. hanks might well need to increase their irce re\erves. however. 6.
See Edwards
(IYShb).
7. On Korea’s legal capital controls see. for esample. the International hlonetary Fund’s, .-\H/I& Rt,porr 011 EXCllNllgC CoJrfrols ( 19S5). 8. See Edwards and Khan (lYS5) for a related model and estimates for Colombia and Singapore. Edwards (1986a) estimated a somewhat similar model for Chile. 9. For a discussion of the recent Korean exchange rate policy see World Bank (1987) and Edwards (1986b). 10.
See World
Bank
Il. van Wijnbergen tion.
(1987). (19S-h)
analyzes
a similar equa-
191
MORLD
DE\‘ELOP\lEN-l
12. Equation (S) had to be esttmated ustng annual data. since there is no long quarterly time scrtes on tnvestment. The following Instruments uerc used: esports. intlatton, exchanye rates and lagsed values of all the variables in the rstimatton of (S).
13.
This. of course, has been a consequence of Lucas’ inllurntial criticism of the sconometrtc/ forecasting practices of the IYMts and first half of the LY7Os.
( IY76)
REFERESCES Buffie. E.. “Financial repression. the new structuralists and stabilization policies in semi-industrialized economies.” /owrrnl of Dne~opnttwf Ecorromics (April lY7-f) pp. 305-322. Cheong. M.. “Macroeconometric model for the Korean economy,” Qmrrler!\’ Ecowmic Rrr~irw (December lYY3). Cho. Y. J.. “Capital market structure and b‘trricrs to financial liberalization.” Unpublished manuscript Washington. DC: The World Bank. (July. IYSS). Edwards, S.. “Monev. the rate of devaluation and interest rates in a -semi-open economy: Colombia. 196&-1982.” /owrrul of‘ IClorw~. C&i/. crrrtl BtrrtXi,tg (February 19X5). Edwards, S.. “Monetarism in Chile: Some economic Ecotrotnic Developr~twr curti Culr~trrrl puzzles.” Char~ge (Frbruarv 19Y6a). Edward‘s. S., “The~Korean macrosconomv.” Unpublished manuscript Los Angeles: (Univerky of California, 19S6b). Edwards. S.. and M. Khan, “Interest rate determination in developing countries: a conceptual framework.” IMF Srctjy Papers (September 19S5). Kim. Joon-Woong. “Economic development and financial liberalization in Korea: Policy reforms and future prospects.” Paper presented at the l9SC Joint Conference on Industrial Policies of the Republic of China and the Republic of Korea (Seoul: Sovembsr 19S5). Kwack, S. Y., “Policy analysis with a macroeconomic
model of the Korean economy.” VVashtngon. DC: The World Bank. 1%). Lucas. R.. “Econometric policy evaluatil~n: A critiin K. Brunner and A. Meltzrr (Ells.). T/w qUt2,” PhiNips (‘lrrve (lnd Lrrhor Murkeiv (.Imsterdam: North-Holland. lY76). 1lcKinnon. R. I. ~%/o!rq crrttl Cq>irtr/ t)t Ecc~rrorrtic L)c~&,wwrrr. (Washington. DC: Brookin+ Institution. 1973). Park, Y. C.. “The unorganized financi.tl sector in Korea. 19-15-1975” Washincton. DC: The World Bank. lY76). Park. Y. C.. “Economic stabilization and libcraltzation in Korea: IYStkl9SJ.” Mimeo (Seoul Korea Uniwrsity. lYS5). Shaw, E., Fit’rrrrt~citrl Dee,wtriu,q itr Eco~tot~rt~~ Developwc~t( (Oxford: Oxford University Press. lY73). van Wijnbergcn. S.. 5tagtlationary effects of monctary stabilization policies: A quantitative .tnalysis of of De~~elopt~re~rr E~wtrovtic.s. South Korea.” Jourtd Vol. IO (19%). van Wijnhergen. S.. “Credit policy. intl.ttion and growth in a financially repressed econom> .” Jo~trd of Developt~re,~/ Ecown?, (August I’)Sla I. van Wijnbrrgen. S.. “Interest rate managcmcnt in the LDCs,” Jwrd of Motre/ctr~ Ecot~o~~~ics (September IYXJb). \Vorld Bank. h’orcwt :L/trrrrrgi,r,gr/n* /rrtltt.srri~r/ Trwtviriort (Washington. DC: World Bank. IYS7).
I. pp. ISS-194.
0305-7%?c/SS
I%%.
0
Financial Deregulation and Segmented Markets: The Case of Korea SEBASTIAN University
53.00 + 0.00
19SY Pergamon Press plc
Capital
EDWARDS*
of Cdifortria,
Los
Angeles
Summary. - This paper deals with the relation hetuern the official and the unregulated (or curb) segments of the capital market in Korea. The pupcr focuses on the behavior of officially controlled interest rates paid on time dcpohits and on freely determined curb market interest rates. The effects of financial deregulation on intrrcst rates. Investment and growth are investigated. It is argued that under some (plausible) circumstances financial deregulation can prnrratc significant crowding out in the curb market. reducing the total deyrec of financial intermediation. The empirical results provide some support to the crowding-out hypothesis, and indicate that changes in the officially controlled time deposit rate have bwn positively related to changes in the ~~Orcgatcinvestment function is also estimated freely determined curb market intcrcst rate. An a,, for Korea. It is found that an increase (dccrcase) in the curb rate discourascs (encourages) invcstmcnt; on the other hand, incrcabes in the real volume of credit intermediate in the official scgment have a positive effect on real a~~rcgate inw’rtment.
credit
allocation. The no-market clearing interest rates were reflected on the continued importance of the unofficial or curb fitrcrt~cid markrt.’ In fact, the segmented nature of the Korean financial market - where this curb segment coexists kvith the official financial institutions makes the analysis of the possible effects of financial policies particularly interesting and difficult. For example. under capital market segmentation it is possible that the liberalization of the official segment will result in a reduction of the overall degree of intermediation. This would be the case. for example. if as a result of the reform the degree of intermediation crowded out in the curb market exceeded the increase in intermediation in the official segment. In this paper I analyze the interaction between the official and curb capital markets in Korea. The paper focuses on the relation between official interest rates on time deposits in the control-
1. INTRODUCTION In lYS1, Korea’s Fifth Five Year Plan established as one of its goals the liberalization of the country’s financial sector. In the following years a number of steps towards reforming the capital market were actually taken. The main characteristics of these reforms were: (a) new financial instruments were created: (b) some measures geared at increasin_r competition among banks were implemented, Including the privatization of commercial banks, and the granting of permission to foreign banks to participate in a number of areas previously restricted to domestic banks; (c) banks were allowed to increase the scope of their business beyond intermediating time deposits: (d) overall competition in the financial sector was encouraged by giving a more important role to non-bank financial institutions; (e) explicit government intervention in the allocation of credit was reduced; and (f) a somewhat greater degree of flexibility in terms of the interest rate which banks could charge on their loans was allowed. ’ In spite of these important steps towards deregulating the financial sector, by late 1986 a number of controls were still in place. Particularly important among them were the fixing of interest rates at non-clearing levels, and government’s implicit interference in the process of
‘This paper draws on a report written for the World Bank in February 1986. Discussions with Farrukh Iqbal have been very helpful. Danny Leipziger. S. Y. Kwack and Tony Chan provided very helpful comments. The views presented here are those of the author. and do not necessarily reflect those of the World Bank. This research has been supported by National Science Foundation Grant # S-l 19931.
I85
IS6
M’ORLD
DE\‘ELOPhfENT
led segment. and freely determined interest rates in the curb market. and discusses the probable effects on interest rates. intermediation. and investment. of policies aimed at further dereguluting the Korean financial market. This analysis is particularly relevant since it is expected that during the next few years Korea will undertake steps towards further “liberalizing” its financial sector, by raising interest rate‘s paid on time deposits and rehising some of the esibting controls on international capital llovvs. The paper is organized in the following form: Section 1 is the introduction. In Section 2 some important implications of financial liberalization policies in a segmented capital market setting are briefly discussed. In Section 3 the historical behavior of official and freely determined interest rates in Korea is briefly presented. In section -I a model of interest rates determination in a semiopen economy is developed and used to analyze the behavior of Korea’s curb market interest rates. It is found that freely determined (curb) interest rates have responded to a number of variables, including changes in overall domestic liquidity. expectations of devaluation. world interest rates. and official interest rates paid on time deposits in the controlled segment. In Section 5 an investment function is estimated for Korea. The results obtained show that the investment ratio has been negatively related to the curb market real interest rate, and positively related to the real availability of credit in the official segment. Finally, Section 6 contains the concluding including some implications of the remarks, empirical analysis.
7. FINANCIAL LIBERALIZATION. INTEREST RATES. SEGMENTATION ECONOhIIC ACTIVITY
AND
official segment or curb market.’ XI a result of this. total intr’rmedlatic~n may actually decline. rather than increase. as the conventional vie\\ suggests. van \i’ijnbrrgen ( l%4b) developed a formal portfolio model of a financially “repressed” economy to analyze theoretically the effects of a financial reform in a country with a segmented capital market. The capital market consists of two segments: the official banking sector, vvhich is subject to government regulation and interest rate controls. and the informal or curb segment. where interest rates are freely determined. In this model households can allocate their wealth across three assets: (1) currency: (2) time deposits in the official banking sector: and (3) loans in the informat curb market. It is assumed that all three assets are gross substitutes. so that an increase in the return in one asset reduces the amount demanded of the other two. In this model the official banking sector is subject to a positive. and relatively high, legal reserve requirement.’ In the curb market, however. there is “direct intermewith a one-to-one relation between “dediation.” posits” and loans. The demand for loans comes from firms. Naturally, since interest rates charged by banks in the official segment are below market level - that is. after all. the definition of financial repression firms are eager to get as much funds as possible at this lower rate. Equilibrium in the curb market is established when the supply of loans to this segment SCurh( ) is equal to the demand for this type of loans. This demand, in turn is equal to the firm’s total demand for loans DT( ) ~?~in~s the banks’ supply of loans in the official segment. SnanLr( ), Since in the official segment there is a reserve requirement CL, banks can only lend a fraction (l-u) of their time deposits (this ignores free reserves). Equilibrium in the curb market can then be written as: Scurh( ) = Dr(
According to the more traditional financial repression view of Shaw (1973) and McKinnon (1973). in a country with rudimentary capital markets a financial reform that raises interest rates paid on time deposits will increase savings, increase investment and ultimately result in higher growth.’ Central to this analysis is the idea that by reforming the financial sector, funds will flow from unproductive uses, such as real estate speculation, gold, or foreign exchange holdings, into the formal financial system, with the subsequent increase in net intermediation. Recently, however, it has been argued that in countries with a large informal financial market. \uch as Korea, the liberalization of interest rates in the official segment will croi~ri OUTfunds from the un-
) _ SnallL\( ),
(1)
In this simple setting, an administrative increase of the interest rate paid on time deposits in the controlled sepment will have two interrelated effects. First, asset holders will reshuffle their portfolios, moving away from both loans to the curb market and from currency, and into time deposits. That means that SCurh( ). in equation (1). will go down. Second, as a direct consequence of the increase in the volume of time deposits, the bank will be able to increase their loans to firms - SB’““( ) will increase. However, since in the official segment reserve requirements are positive (and relativelv high). bank loans will only increase by a fraction (l-u) of the increase in time deposits.
FINANCIAL
What will happen to interest rates in the curb segment? They can increase or decrease. depending on the degree of substitutability of time drposits and curb loans in the private sector portfolios. and on the rate of reserve requirements of deposit money banks. If time deposits and curb loans are very close substitutes. most of the increased volume of time deposits following the increase in official interest rates will come from lower curb loans. In terms of equation (1) .Scurh( ) will experience an important decline. If. in addition. banks’ reserve requirements are high. the banks’ supply for loans will increase by a relatively small amount. As a result of this, interest rates in the curb sector will probably increase, with total intermediation declining. If. on the other hand. time deposits are very close substitutes with currency. interest rates in the curb sector will tend to decline, and total financial intermediation will increase. as suggested by the conventional view. In this case, most of the increased volume of time deposits following the increase in official interest rates will come from lower holdings of currency. It follows from the above discussion that whether in a particular case the financial liberalization reform will work in the traditional way. increasing the total volume of financial intermediation, or in the fashion suggested by the reform critics is an empirical matter. Unfortunately it is a difficult empirical question. since many of the required data to perform the analysis and especially those pertaining to the informal curb market many times are not available. Although in almost every case there are no data on the volume of intermediation that takes place in the informal or curb market, there are some indirect ways of analyzing the effects of a liberalization reform on the curb market. More specifically. if there are data on curb interest rates. it is possible to indirectly test the crowding out hypothesis, by analyzing the effects of changes in interest rates paid on time deposits on curb market interest rates. From an empirical point of view. then, an indirect test of the crowding out hypothesis would consist of estimating whether, with other things given, a higher interest rate paid on time deposits in the official market results in an increase in the curb market interest rate. Sections 3 and 4 are. in fact. devoted to an empirical analysis of this type for the case of Korea.
3. OFFICIAL INTEREST Table
AND CURB MARKET RATES IN KOREA
1 contains data on different
interest
rates
157
DEREGL’LATION
Table
1. Interest rues in Korea tirrtuj
197745
(quurterly
Reid Time
Nominal
YKlr and quarter
Curb rate
deposir
1977:3 lY77:1
35.5 a-r.0
16.2 l-t.3
15.0 15.0
21.8 30.5
75 1;:x
I.3 11.5
197s: 1 197s:z lY7S:3 lY7S:J
3S.1 3s.-J 43.2 46.S
14.4 1S.O IX.6 IS.6
15.0 Ii.0 IS.0 18.5
14.1 26.0 23.9 35.3
-Y.Y 5.6 -0.7 7.1
-9.3 2.6 - I.3 7.0
197’): I 1979:’ lY7Y:3 lY7Y:J
44.0 42.0 40.7 42.7
18.6 18.6 18.6 18.6
19.1 19.0 19.0 19.0
25.s 9.0 29.0 27.5
0.4 -14.5 6.9 3.4
0.9 -14.1 .7.3 3.x
IYXO:I 1980:2 19so:i 19so:1
5O.Y 4.x 42.5 37.7
23.3 ‘4.0 22.9 21.4
24.3 1-1.7 23.7 1O.S
1.1 11.3 21.6 4.5
-23.4 - 10.5 1.0 -11.8
-12.4 -Y.S 2.8 -17.4
1YYI:l lYS1:2 19SI:3 1981:-i
36.6 35.2 33.Y 35.4
IY.5 IY.5 19.5 19.0
20.0 20.0 20.0 lY.O
19.5 15.7 12,s 32.7
2.4 0.0 -1.5 16.3
2.0 0.5 - I.0 16.3
1981: I 1982:2 19x7:3 19S’:J
32.6 33.1 27.5 79.0
15.1 12.5 8.0 8.0
16.1 13.Y 10.0 10.0
27.8 26.3 21.3 2S.1
10.3 5.7 1.8 7.1
11.3 7.1 4.S 9.4
lYS3: I 19s3:2 1983:3 19s3:1
24.1 27.5 26.8 24.7
S.0 8.0 8.0 8.0
10.0 10.0 10.0 10.0
16.3 26.1 26.2 24.7
0.z 6.6 7.1 s.0
2.2 8.6 9.1 10.0
lYS-1: 1 198-t:? 1984:3 19s4:1
21.1 25.7 23.5 B.-l
10.0 10.0 10.0 10.0
10.1 10.5 IO.5 11.1
18.2 23.5 22.1 24.2
4. I 7.8 S.6 8.8
4.5 8.3 9.1 9.9
19S5: 1 19Sj:Z
27.7 27.0
10.0 10.0
11.5 Il.5
21.2 Z-l.1
6.5 7.1
S.0 8.6
Source:
Bank
Time rate
Loan Curb rate rate
deposit
rate
Loan rate
of Korea.
in Korea for 1977-85. The real rates have been computed using the annualized rate of inflation for the corresponding quarter. As may be seen. until 1951 there was a profusion of negative real rates. However. starting with that year - and as a result of the measures undertaken as part of the Fifth Five Year Plan - all interest rates included in the sample have been consistently positive. Moreover. between 1984 and 19% real rates, both in the official and controlled financial seg-
I xs
N’ORLD
DEb’ELOPhIEYT
bvere quite high. Fur esample. during IYSS the real interest rate on loans in the official market averaged approsim:ttf2l~ Y’!,, per qr;lr. The correspondins real rate on time deposlth in the commercial hanks a\eragrd Amost S”,, per annum. In spite of this sharp incrtxw in real wtes in the official market and of the addition~~l tleuibility introduced by the Fifth Plan on Icndin~ r:ttcb which allowed banks to charpe anything between lO’:i, 2nd I I.5’!’ o - in late IYSS there \vere still indications that a situation of escess demand for funcls persisted in the official segment. Thi$ escess demand was retlected in two basic M’;I~s. First, as indicated above. the curb market activities continued to be bery important and the interest rate differential between the organized and unorganized segments rscrrds anq ~~re:tsonable” risk premium. Second. there iv;15 aidence sug
Figure I depicts the behavior of the official nominal interat rate paid on time &posit>. the curb nominal rate. and the US Treasury bill ratr‘. which is used LIP ;I prosy for world interest rata. As can be seen the spr& between the freeI> &termined curb rate and the other two interat rates have been Ggnificant and perhibtent. It is particularly interesting to note that throughout the period the spread between the curb rate and the US Treasury bill exceeds. by ;I wbbtantial margin, any reasonable estimate of the expected rate of devaluation of the u.on.h Also. notice that in the more recent period the officially pegped time deposit rate has mobed closely with the US T-bill rate. As ;I preliminary step in the analysis of interat rate behavror rn the unottrcr;ll sector some regressions relating the curb market rate and the officially fixed time deposit rate were estimated. The regressions used both yearly data for IYW-S-I and quarterly data for 1977-M. The yearI> regression using ordinary least squares (OLS) bieldrd the following result. where the number in parentheses are t-statistics: Curb =
0.169 (7.605)
+
0.146 (112YZ)
TDK
Ii’ = O.YOl D.VV’. = 2.087 (2)
The quarterly regression KIS estimatai ordinary least squares corrected by first
using order
FINANCIAL serial correlation. lY77-X5 only. Curb
=
0.167 (-l.-t-h))
and used data
+
for
I. IS0 TDR R’ D.iV. (5.17-I)
DEREGCLXTION
the period
= O.-ISY = l.S-I7(3)
IXY
of devaluation. In Edwards (1YS.i) I have argued that interest rate behavior in a small semi-open economy can be captured by the following equation:’
Ai, = O[(iW, + D, + P,) - i,-,] - k[log L,_, As many be seen in both cases the coefficient of the time deposit rate is positive and significant. some preliminary support to the providing hypothesis that during these periods administered increases in the time deposit rate in the official market provoked crowding out in the financial market. Of course. a problem with these regressions is that they ignore the possible intluence of other variables in the determination of the curb market interest rate. In the section that follows a more complete model of interest rate behavior in the free (curb) market. that incorporates the role of foreign variables as well as domestic liquidity is estimated to further analyze this issue.
1. A MODEL OF INTEREST RATE DETERMINATION IN KOREA The regressions above [equations (2) and (3)] showed that there has been a significantly positive relation between officially fixed nominal interest rates and the freely determined interest rates in the unofficial or curb market. However, in order to fully understand the behavior of interest rates in the free segment it is necessary to have a more complete model of interest rate behavior. In particular. one would like to have some idea on how the interest rates react (if at all) to changes in world interest rates. changes in the expected rate of devaluation, and to changes in domestic monetary and credit policies. Most empirical studies on interest rate behavior have made extreme assumptions regarding the degree of openness of the economy. It has been generally assumed that the country m question is either completely closed to the rest of the world or that it is fully open and that there are no capital controls. These extreme assumptions are. of course, inadequate for middle-income countries such as Korea, where the degree of openness corresponds to some intermediate situation. The capital account is partially open and there are some controls to capital movements.’ Presumably in a semi-open economy with some legal restrictions to capital movements - interest rates will be affected in the short to medium run by both closed economy factors, like the situation of excess demand or supply for total real liquidity in the economy, and open economy conditions such as world interest rates and the expected rate
- 10s L:’ ]
(-I)
where i is the domestic nominal interest rate for a particular financial instrument; iW is the world interest rate for instruments of the same characteristic as the domestic ones (with the exception of currency of denomination); D is the expected rate of devaluation: P is a risk premium factor; ,!. is a measure of real liquidity in the economy (i.e.. broadly defined money or domestic credit. for example); and L” is the real quantity of this liquidity aggregate desired by the public (I.e.. the real demand for money or domestic credit). This equation combines open and closed economy factors as possible determinants of the domesttc interest rate. and lets the data reveal what is the actual degree of economic (as opposed to legal) openness of the economy. The first term in equation (-I) captures the open economy factors affecting domestic interest rates. It states that there will be some forces in the economy that uill cause interest rates to move (slowly) through time in the direction sugpested by the uncovered interest parity. The speed and extent at which that movement will take place will depend on the parameter 0. The second term of this equation refers to the closed economy factors affecting the interest rate in the short run, in this small open economy. It states that, with other things given. an excess supply for real liquidity (i.e., money) will exercise a downward pressure on the domestic interest rate. An important property of equation (4) is that the extreme situations of fully open or completely closed economies are particular cases. If the economy under study is completely open to capital movements. we would expect that 0 = 1 arrd ii = 0. In that case equation (4) becomes an interest arbitrage condition, where the domestic interest rate is equal to the world interest rate plus expected devaluation and risk premium. If, on the other hand, the economy is completely closed to foreign influences. it would be expected that 0 = 0 and k 2 0: the domestic interest rate will depend only on domestic monetary factors. Intermediate cases of semi-open (semi-closed) economy will have positive 8 and J.. Notice that according to equation (3). in the long run of the semi-open case there will be monetary equilibrium (log L = log ,“I. and the domestic nominal interest rate will depend on open economy factors only. However. because of the existence of a
WORLD
190
DEVELOPblENT
risk premium term P,. even in the long run the domestic nominal interest rate can (and usually will) differ from that world rate plus expected devaluation. One of the most attractive features of this model is that it allows the data to reveal vvhether a country is financially “open” or ‘-closed.” In fact. this model allows for discrepancies between the legal and the economic degrees of --openness.” In order to empirically estimate (-I) it is first necessary to specify the demand for real liquidity function L”. Following Edwards (1985) and Edwards and Khan (1985) we consider a semilogarithmic demand for real money function: log L’f = b,, + b, logy, - 62 i,
(5)
where y is real income, and where bi and 62 are positive parameters. Combining this demand for L equation with the interest rate equation (-1) presented above, the following reduced form for interest rate determination in semi-open economies, can be obtained (where E, is an error term with the usual properties): i, = PO + @,(iCV, + D, + P,) + &i,-, + p, log 172,_, + p_Ilogy, + E,. The l3 coefficients tural parameters PI=
p3=
in (6) are related to the strucin the following way: p_ =
8 (l+hb?)
’
-I
:
(l+hb,)
(6)
’ p4 =
(I-e)
(l+hbz)
;
hbl (l+hb?)
Equation (6) refers to the determination of the market, freely determined nominal interest rate. In that regard, within the Korean framework. i has to be interpreted as the curb market interest rate. A problem with this equation, however, is that it does not incorporate in any way the fact that in Korea there is a segmented capital market where the official (controlled) and the unofficial markets coexist. In order to capture this segmentation, and more specifically the possible effect of changes in the administratively determined term deposit rate on the curb interest rate, an additional term (l3s TDR,) can be added to equation (6). where as before TDR stands for time deposit rate. Modified equation (6) - which adds the official time deposit rate - will then allow us to know how “financial liberalization policies” (i.e., policies that raise TDR), as well as exogenous shocks, have affected the freely determined interest rate in Korea. The reduced form equation
to be estimated is the following (where u is an error term assumed to have the usual properties): i, = fir, + B,(iLV, + D, + P,) + \32i,_, + 13:log L,_ , + fi1 lay y, + fis TDR, + lt,
(7)
where it is expected that fii > 0. l& > 0. l3; < 0. l& > 0. The coefficient of TDR can be positive or negative. A negative & will indicate that the results of the conventional model have prevailed in Korea. A positive pi. on the other hand, will be a reflection of the relevance of the alternative portfolio model with close substitutability between time deposits and curb loans. If the crowdin.g, out hypothesis is true. and increase in the otficially determined rate will, with other things given, result in higher interest rates in the free segment. and we will find that p5 > 0. In the estimation of equation (7) some decisions have to be made in terms of the data actually used. i is the curb market rate as collected by the Bank of Korea (see Table 1). iW is the US Treasury bills rate. In some regressions not reported here, however. the LIBOR rate was used instead. with no effects on the results. The definition of D,, the expected rate of devaluation. is particularly difficult. In this paper it was proxied by the actual rate of devaluation. This simplifying assumption. which is consistent with the perfect foresight variant of the rational expectations view. is not unreasonable for Korea in the recent period since. starting in early 1980 the won has been following a fairly slow moving rate of crawl.” With respect to the risk premium term it was assumed that it was equal to a constant plus a random term with the usual characteristics. y is real GDP as computed by the Bank of Korea. Two alternative variables were used as proxies of real liquidity. The first was domestic credit (denoted by DC) and the second total debts of the banking sector (denoted by Db). The time series for both of these variables were obtained from the International Financial Statistics. In other regressions not reported here M2 was used. without affecting the results. Before estimating equation (7) it is also necessary to make a judgment regarding the exogeneity of the time deposit rate. If the monetary authorities determine TDR based on criteria that are unrelated to the behavior of the curb market interest rate, it is legitimate to consider TDR as exogenous, and to estimate (7) using ordinary least squares. If, on the other hand, in order to determine the official TDR the monetary authorities follow a feedback rule that takes into account the behavior of the curb rate in the same period. equation (7) should be estimated using instrumental variables. Since there is no indica-
FINANCIAL
tion that the Korean monetary authorities have actually considered the behavior of the curb rate when altering the level of TDR. in this paper equation (7) was estimated using OLS.“’ Table 2 contains the results obtained from the estimation of equation (7) for interest rate determination using ordinary least squares on quarterly data. Equation (7.1) was estimated using real domestic credit (DC) as the relevant real liquidity variable, whereas in equation (7.2). total real bank debt (Db) was used as the liquidity variable. The results are quite satisfactory. First, all the coefficients have the expected signs. Second, with the exception of y in both regressions, all of them are significant at either the 5 or 10% levels. It is interesting to note that the estimated values (point estimates) of some of the coefficients are quite low. suggesting that on average the curb market interest rate may have reacted with some sluggishness to different types
Table
2. Nornitd
rernlinnriorl qttnrterly
irlteresr rule tlein Korea, 1978-S: data (ordirwry lecrst squcwes)
Eq.
(7.1)
Eq.
(7.2)
constant
0.47-I (1.769)*
0.4 I (1.560)
(iW,
O.OSI (1.977)
0.076 (1.710)
0.47-l (3.013)
OS-13 (3.423)
L
+ D,)
I
log
DC,_,
log
Db,_,
-0.081 (-2.661) -
-
0.049 (-2.112)
1% .v,
0.076 (0.276)
0.024 (0.858)
TDR
0.371 ( 1.974)
0.290 (1.800)
ri’t
0.841
0.873
D.W.;
1.83
1.50
‘The numbers in parentheses are tstatistics. tI?’ is the coefficient of determination corrected by degrees of freedom. tD.W. is the Durbin-Watson statistic.
I91
DEREGULATION
of shocks. Broadly speaking, the result in Table 2 indicate that the freely determined curb interest rate in Korea has reacted both to closed and open economy factors. More specifically. freely determined (curb) interest rates have responded to (a) changes in the expected rate of devaluation and in the world interest rate; (b) changes in the conditions of real liquidity in the economy; and (c) changes in the officially controlled time deposit rate. The estimates of the coefficient B in Table 2 indicate that with other things given, an increase in the officially administered time deposit rate of one percentage point have been reflected in an increase in the freely determined curb market rate of approximately 0.4-0.3 percentage points (30-40 basis points). Notice that the coefficients of TDR in equations (7.1) and (7.2) are significantly smaller than the estimate obtained in equation (3), indicating that ignoring other variables [as in (3)] can result in significant bias and misleading results. From the empirical results in Table 2 it is possible to calculate the coefficients 0 and h in equation (6). These coefficients provide information on how fast a particular disequilibrium is transmitted into domestic interest rates. For example from regression (7.1) it is obtained that 8 = 0.15 and k = 0.16. In terms of the influence of open economy factors, this means that an increase in the expected rate of devaluation, or of world rates of interest, of 10 percentage points will be translated into a higher curb market nominal rate of little less than one percentage point during the same quarter. After six quarters the curb rate would have increased by approximately four percentage points. In that regard, these results show that Korea is in fact a semi-open economy;where open economy factors have a non-negligible influence on interest rates behavior.
5. CURB FINANCIAL MARKET, SEGMENT, AND INVESTMENT
OFFICIAL IN KOREA
In the preceding section it was empirically established that. with other things given, increases in the official rate have historically resulted in higher curb market interest rates. What still has to be investigated is how increases in time deposit rates have affected investment. This can be analyzed by estimating an equation that incorporates the potential roles of both the curb and official segments of the capital markets on funds availabihty and investment. Once more, however, there are data problems. First, as already noted, there are no data on the volume of intermediation in the curb market. Second, there are no data on the virtual interest rates that clear
192
WORLD
DE\‘ELOPXIENT
the rationed official markt. For this reason ;I compromised investment function has to he estimated using the available data. In the present studv the following equation was considered.” INVR,
= ‘{,) + *i, INVR,_,
+ ‘/; DLOAN,_,
+ yz CURBR,_,
+ *~,(_Y,-,--).~-~)
+ +,
(S)
where INVR is real aggregate investment, CURBR is the curb market red interest rate. DLOAN is the rcwl flow of news loans in the official financial sector. and (?,,-I-y,-2) is an accelerator term. withy being real output. Under the hypothesis that both the official and curb markets affect investment. it is expected that the coefficient of CURBR would be sipnificantly negative. indicating that a higher real interest rate in the free segment discourages investment, while that of DLOAN would be significantly positive. This is because a hipher value of DLOAN reflects a higher degree of intermediation via commercial banks. and thus availability of funds. in the official segment of the capital market. In order to take into account possible problems stemming from the error in measuring the rcctl curb market interest rate. xi instrumental variables estimator was used. DLOAN was constructed using data on total real IWIIS. with the raw data being taken from the IMF /~r/crr~rrriortn/ Fi~rtrr~cirrl Strrtisrics. Since in preliminary fits the residuals from (S) exhibited negative sertal correlation. the estimation was performed usins Fair’s method for correcting instrumental variables estimates for first order autocorrelation. The estimation of (8) using annual data for 196%S3 yielded the following result where the numbers in purentheses are r-statistics.” 22.927 (2.920)
+
0.752 (17.S57)
INVR(-
1)
0.490 [v( - l)-y(-2)] (3.361) O.S-IS (-3.705) + 1.907 (5.398)
CURBR(-
1)
DLOAN Rho = -0.68
(9)
These results. then, provide statistical support to the hypothesis that real investment behavior has been influenced by developments in both the official and curb segments of the capital market. These estimates are in line with van Wijnbergen (1984,). who used a similar specification to estimate a private sector function and also found that both loans and the curb real rate were
important.
Other studies. however. have been in identifying the importance of both elements in the determination of investment. For esample in his estimates for nonhousing private investment. Cheons ( 1983) obtained a significantly positive real liquidity term. and an insignificantly negative coefficient for the real curb market rate. Knack (1985) did not incorporate the curb market interest rate in his investment function. It‘s> successful
6. CONCLUDING
REMARKS
This paper has dealt with the effects of financial liberalization in the presence of a setemented capital market. as in the case of Korea. It was pointed out that under the type of institutional arrangement prevailing in Korea a financial reform that raises interest rates in the official segment is likely to crowd out funds that were previously intermediated by the curb market. Whether as a result of the reform tolc11intermediation (in the official and curb segments) will increase of decrease will depend on a number of variables. including reserve requirements in the official segment. optimal precautionary reserves in the curb market. and various elasticities. An empirical model of interest rate detrrmination in a small economy with capital controls was estimated. It was found that nominal curb market interest rates in Korea have basicall> responded to three forces: (a) the evolution of real liquidity in the economy; (b) open economy factors. such as world interest rates and espected dev~aluation: and (c) officially fixed interest rates in the orpanized segment. With respect to this last factor it was found that, with other things given. higher (lower) official rates paid on timct deposits have resulted in higher (lower) curb market rates. This positive relation beween the time deposit and curb market nominal interest rates provides some support for the crowding out hypothesis. An aggregate investment function was estimated in order to have an idea of how financial reform has affected capital accumulation. Both the change in the total level of real domestic credit in the official segment and in the curb real interest rate were included as independent variables. The results obtained show that both of these variables have influenced the behavior of aggregate real investment in Korea. Hisher curb rates discourage investment. while faster growth of real credit in the official segment encourages investment. By now most economists accept that it is difficult if not outright incorrect to use estimated equations based on historical data to
FINANCIAL
IY.3
DEREGULATION
(mechanically) forecast the future.” In our case. however. we can use the information obtained from the estimation of the interest rate and investment equations to tiiscltss the possible evolution of some critical variables in Korea in the years to come. First. to the extent that. as is anticipated. Korea embarks on more ambitious financial reforms. we will observe structural changes in equation (7) on nominal interest rate behavior in the free (curb) market sector. For example, the relaxation of existing controls to international capital movements will possibly result in an increase in parameter 8 and in a decline in 1. This means that freely determined domestic interest rates will possibly move more closely with world interest rates. This, of course. is nothing else than a reflection of the fact that in economies that have a more open capital account the authorities’ ability to influence interest rates (even in the short run) is greatly reduced. In a way. then, a higher degree of financial openness to the rest of the world will very likely reduce the monetary authorities’ ability to intluence some key macroeconomic variables. A greater degree of openness of the capital account will also have important consequences for the interaction between exchange rate policies and the domestic financial sector. The higher is 0. the more quickly will expected changes in the exchange rate be translated into htpher domestic interest rates. This suggests that in the future there will be some trade-offs related to a
more active manipulation of the nominal exchange rate. if Korea pursues the publicized goal of putting an end to the reliance on foreign savings, a more active eschange rate policy geared at penerating real devaluations will probably be implemented. If this means that there will be a faster rate of crawl of the nominal exchange rate. we will likely observe higher domestic nominal (and real) curb interest rates. which in turn will be translated into lower aggregate investment (recall the estimates in equation (S)). The results from equation (S) suggest that increase in the time deposit interest rates have exercised two kinds of forces on investment. Notice. however, that as the ‘-financial reform” continues, we possibly will also observe important structural changes in this equation. In particular as the importance and coverage of the curb market declines with the liberalization. so will the coefficient of CURBR in (S). In the limit. of course, the curb segment will disappear all transactions will take place in the free “official” segment and CURBR will cease to be a relevant variable in the investment equation. Notice however, that if Korea maintains its traditional prudent approach to economic reform. this process of structural decline in the importance of CURBR in the investment equation will take some time, and we can espect that in the next few years the developments in both the official and unofficial segments will continue to influence real investment.
NOTES I, On the recent evolution of Korea’s financial seetor see Park (1976. 1YS.i): World Bank (lYX7): Cho (1985); and Kim (I’M). 2. There are some indications. however. that during the last few years the size of the unofficial or curb market has declined. For example. a survey performed hy the Citizen National Bank indicates that betvvcen IYt(0 and 1983 households have steadily decreased the fraction of their savings channeled through the curb market from 70.2% of total savings to 3Y.2% (see World Bank. 1987). 3. According to this approach the initial conditions are characterized bv artificially low nominal rates. which usually result in negative recll interest rates. See Shaw (1973) and McKinnon (IY73). 1. See. for example. (198Ja. 19Ylb). 5. Although the Korea is only 4.5%. dential factors would ratio if liberalization
Buffir
(1981):
van Wijnbergen
current reserve requirement in it may well be expected that prulead to an increase in the reserve achieves one of its objcctivcs ol
freeing banks from government involvement. At present, that ratio is non-opcrativc in an\ real \cn\c ~3 loans exceed deposits hy as much as 21l”,, financed by the Bank of Korea. With geater autonomy. hanks might well need to increase their irce re\erves. however. 6.
See Edwards
(IYShb).
7. On Korea’s legal capital controls see. for esample. the International hlonetary Fund’s, .-\H/I& Rt,porr 011 EXCllNllgC CoJrfrols ( 19S5). 8. See Edwards and Khan (lYS5) for a related model and estimates for Colombia and Singapore. Edwards (1986a) estimated a somewhat similar model for Chile. 9. For a discussion of the recent Korean exchange rate policy see World Bank (1987) and Edwards (1986b). 10.
See World
Bank
Il. van Wijnbergen tion.
(1987). (19S-h)
analyzes
a similar equa-
191
MORLD
DE\‘ELOP\lEN-l
12. Equation (S) had to be esttmated ustng annual data. since there is no long quarterly time scrtes on tnvestment. The following Instruments uerc used: esports. intlatton, exchanye rates and lagsed values of all the variables in the rstimatton of (S).
13.
This. of course, has been a consequence of Lucas’ inllurntial criticism of the sconometrtc/ forecasting practices of the IYMts and first half of the LY7Os.
( IY76)
REFERESCES Buffie. E.. “Financial repression. the new structuralists and stabilization policies in semi-industrialized economies.” /owrrnl of Dne~opnttwf Ecorromics (April lY7-f) pp. 305-322. Cheong. M.. “Macroeconometric model for the Korean economy,” Qmrrler!\’ Ecowmic Rrr~irw (December lYY3). Cho. Y. J.. “Capital market structure and b‘trricrs to financial liberalization.” Unpublished manuscript Washington. DC: The World Bank. (July. IYSS). Edwards, S.. “Monev. the rate of devaluation and interest rates in a -semi-open economy: Colombia. 196&-1982.” /owrrul of‘ IClorw~. C&i/. crrrtl BtrrtXi,tg (February 19X5). Edwards, S.. “Monetarism in Chile: Some economic Ecotrotnic Developr~twr curti Culr~trrrl puzzles.” Char~ge (Frbruarv 19Y6a). Edward‘s. S., “The~Korean macrosconomv.” Unpublished manuscript Los Angeles: (Univerky of California, 19S6b). Edwards. S.. and M. Khan, “Interest rate determination in developing countries: a conceptual framework.” IMF Srctjy Papers (September 19S5). Kim. Joon-Woong. “Economic development and financial liberalization in Korea: Policy reforms and future prospects.” Paper presented at the l9SC Joint Conference on Industrial Policies of the Republic of China and the Republic of Korea (Seoul: Sovembsr 19S5). Kwack, S. Y., “Policy analysis with a macroeconomic
model of the Korean economy.” VVashtngon. DC: The World Bank. 1%). Lucas. R.. “Econometric policy evaluatil~n: A critiin K. Brunner and A. Meltzrr (Ells.). T/w qUt2,” PhiNips (‘lrrve (lnd Lrrhor Murkeiv (.Imsterdam: North-Holland. lY76). 1lcKinnon. R. I. ~%/o!rq crrttl Cq>irtr/ t)t Ecc~rrorrtic L)c~&,wwrrr. (Washington. DC: Brookin+ Institution. 1973). Park, Y. C.. “The unorganized financi.tl sector in Korea. 19-15-1975” Washincton. DC: The World Bank. lY76). Park. Y. C.. “Economic stabilization and libcraltzation in Korea: IYStkl9SJ.” Mimeo (Seoul Korea Uniwrsity. lYS5). Shaw, E., Fit’rrrrt~citrl Dee,wtriu,q itr Eco~tot~rt~~ Developwc~t( (Oxford: Oxford University Press. lY73). van Wijnbergcn. S.. 5tagtlationary effects of monctary stabilization policies: A quantitative .tnalysis of of De~~elopt~re~rr E~wtrovtic.s. South Korea.” Jourtd Vol. IO (19%). van Wijnhergen. S.. “Credit policy. intl.ttion and growth in a financially repressed econom> .” Jo~trd of Developt~re,~/ Ecown?, (August I’)Sla I. van Wijnbrrgen. S.. “Interest rate managcmcnt in the LDCs,” Jwrd of Motre/ctr~ Ecot~o~~~ics (September IYXJb). \Vorld Bank. h’orcwt :L/trrrrrgi,r,gr/n* /rrtltt.srri~r/ Trwtviriort (Washington. DC: World Bank. IYS7).