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[Viewpoint] Here’s the problem with hot money

“One of the worst jobs in the world next year is being an Asian central banker,” said an economic commentator to Bloomberg Businessweek, a New York-based weekly magazine. In fact, there are forecasts that the implementation of certain economic policies, especially those relating to finance, will be a great challenge going into next year.

According to the theories of economics, it is impossible to have all three of the following at the same time: free capital movement, independent monetary policy and a fixed exchange rate system. The hypothesis is referred to as the impossible trinity.

Let’s look at an example. Under an independent monetary policy, authorities raise interest rates out of concern for inflation. Next, foreign capital will flow freely into the market. Then, the capital will be used to buy currency to make investments in bonds, causing the currency to rise.

Lately, worrisome movements have been observed in the Korean financial market. Foreign investors are making curious moves in the domestic bond market.

According to statistics, foreign investors hold 80 trillion won ($69.2 billion) worth of Korean bonds, which make up about 7.1 percent of the total. If you just look at treasury bonds, foreigners hold about 15 percent. This year, 21 trillion won has been invested in the bond market, and an additional five trillion won was invested to purchase bonds in November alone. It is certainly a positive factor to have buyers for treasury bonds.

However, we are wary that a considerable portion of the capital is what is known as hot money, which is money that flows into a market to take short-term advantage, seeking higher returns in a shorter period of time.

The problem is that the hot money wants not the treasury bond itself, but the potential revaluation of Korean won. Investors would be able to pocket additional earnings from a higher won on top of the bond’s interest, so they are buying up treasury bonds, expecting the won will rise. And a considerable portion of the recent wave of hot money is Chinese.

There is concern that the funds will leave the Korean market quickly if the strong won trend ends. If $80 billion in funds flow out of the market at once, it would create a serious problem because it makes up about 30 percent of the foreign currency reserve of Korea.

In 2008, about $70 billion left the Korean market from September to the end of the year after Lehman Brothers filed for Chapter 11 bankruptcy.

That resulted in a sudden collapse in the value of the won and stirred the foreign currency market.

In the end, the Korean government brought back market stability after signing a $30 billion currency swap agreement with the Board of Governors of the U.S. Federal Reserve System.

So now we can estimate the potential shock of a sudden escape of foreign investors’ funds.

On Nov. 11, Deutsche Securities conducted massive selling, nearly 2 billion won worth in 10 minutes, and that dropped the Kospi more than 50 points and scorched the market as the expiration of options contracts drew. The transactions were made all at once as analysts concluded that the strong won trend was about to end as the G-20 Summit came to a close, and therefore, it would be advantageous to realize profits as fast as possible.

Recently, the government has decided to reintroduce taxation on foreign investments in Korean bonds and to adopt new taxes on banks. Moreover, various strong follow-up measures are needed to control the intensity of the regulations, such as flexible tax rates.

Fortunately, the G-20 Summit prepared the groundwork to check on the inflow of foreign funds. Also, Korea can now take the initiative of putting financial regulation on the agenda when dealing with emerging economies.

If Korea is the only country to impose tight regulations on foreign investments, Korean markets may be shunned by foreign investors. However, there would be less concern if emerging economies adopt similar regulations on capital inflow and outflow.

Amid complicated economic challenges, Korean authorities would need to use their leverage to set a wise international agenda in order to minimize adverse side effects and maximize benefits of policy implementation.

*The writer is a professor of business administration at the University of Seoul.

By Yun Chang-hyun