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The views expressed in this presentation are the views of the author and do not necessarily reflect the

views or
policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of
Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this
paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be
consistent with ADB official terms.

Implications of Ultra-low and Negative

Interest Rate Policies for Monetary Policy
and Macroprudential Policy in Korea

December 1, 2016

Joon-Ho Hahm
Member of the Monetary Policy Board

The Bank of Korea

The Views expressed in this presentation are those of the author and
do not necessarily reflect the position of the BOK or its Monetary Policy Board.


Macroeconomic Implications
- GDP Growth and Inflation

Financial Stability Implications

- Macroprudential Policies in Korea
- Non-core Bank Liabilities and Credit Growth
- Portfolio Investment and Long-term Interest Rates

Policy Lessons and Conclusion

I. Introduction

For policymakers of open EMEs, important to have better understanding of

cross-border spillover effects of unconventional monetary policies in ADEs

Two opposing views on spillover effects

1) Minimal impacts, and benefits may exceed costs
* higher external demand, lower risk premiums and funding costs, stable economic and
financial environments

2) Risks and negative externalities potentially large

* currency appreciation, external imbalances, credit and asset market booms

Growing volume of research, but no consensus yet

- Dynamic and diverse channels of cross-border spillovers
* Monetary policy autonomy undermined even with exchange rate flexibility (Rey 2013)
* Bond market flows and long-term rates (Miyajima et al. 2014), exchange rates and
bank credits (Bruno and Shin 2015), corporate risk spreads (Chen at al. 2015)
- Dependent on local factors and policy responses of EMEs
* FX regime, external B/S, financial system soundness, macroprudential policies
Cross-Border Transmission Channels (Chen, Filardo, He and Zhu, 2012)

Boost asset prices &

Lower ADE Turn to
lower long-term interest rates
long-term bond yields EM assets
in EMEs
(Portfolio rebalancing channel)

Spur capital flows into EMEs Push up

Boost global
with higher risk-adjusted rates consumer & asset
of return prices
ADEs (Liquidity, asset-price and risk-taking channels)
Investor shift toward asset denominated Appreciation pressures on
in higher-yielding currencies EM currencies

(Exchange rate channel)

Boost demand for EM

Increased spending in ADEs
goods & services

(Trade channel)
II. Macroeconomic Implications

GDP Growth and Inflation

QEs of major ADEs have led to substantial rise in foreign portfolio

investment in Korea

Ultimate impacts on GDP growth and inflation determined jointly

by trade, exchange rate and credit channels

Foreign Investments1) Won/US Dollar Exchange Rate Correlations among

QE Capital Inflows FX Rate1)
(US Dollar, trillion) (Won/US Dollar) (YoY, %)
1.5 1,500 60
Direct Investment Stock Investment
Rate of change (RHS)1) Foreign Won/US$
Bond Investment Derivatives 50 Securities
1,400 Exchange rate (LHS) Portfolio Exchange
1.2 Others Held
40 Investment Rate
Introduction of QE 1,300
0.9 Securities Held 1.00 0.57 -0.61
1,200 20

0.6 1,100 10 Foreign

0 Portfolio 0.57 1.00 -0.75
1,000 Investment
0.3 -10
900 Won/US$
-20 -0.61 -0.75 1.00
Exchange Rate
0.0 800 -30
2007 2009 2011 2013 2015 2009 2011 2013 2015 Note: 1) Correlation among detrended variables; trend of each
Note: 1) End-period balance of stock; IIP basis Note: 1) Year-on-year variable estimated by applying HP filter between Jan.
Source: The Bank of Korea Source: The Bank of Korea 2007 Dec. 2015
Sources: Calculated based on BOKs IIP statistics and securities
held by central banks of US, EU, Japan and UK

Responses of Macro Variables to Increase in Securities Held by
ADE Central Banks

Won/US Dollar Exchange Rate Consumer Price

(%p) (%p)
1.0 0.1


-3.0 -0.4
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
(months) (months)

Industrial Production Gap CD Yield

(%p) 0.05 (%p)



-0.4 -0.10
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
(months) (months)
Note: 1) Solid lines indicate reactions to one unit standard deviation (32.0%p) shock in rate of growth in securities held by ADE central banks;
shaded zones refer to 68% confidence intervals
Source: Nahm and Jung (2016)
Responses of Macro Variables to Decline in ADE Long-term
Interest Rates

Won/US Dollar Exchange Rate Consumer Price

(%p) (%p)
2.0 0.2

1.0 0.1
0.0 0.0
-1.0 -0.1
-2.0 -0.2
-3.0 -0.3
-4.0 -0.4
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
(months) (months)

Industrial Production Gap CD Yield

(%p) (%p)
0.4 0.04


-0.4 -0.08

-0.6 -0.12
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
(months) (months)
Note: 1) Solid lines indicate reactions to 50bp decrease in yields on ADE 10-year Treasury bonds; shaded zones refer to 68% confidence intervals
Source: Nahm and Jung (2016)

Summary of Effects on GDP Growth and Inflation

Positive effects on real economic activity not significant, while negative

effects on CPI inflation and exchange rate seem significant

- UMPs of ADEs Currency Appreciation in EMEs Decrease in Import

Prices Disinflation Pressures

- Liquidity effects seem limited due possibly to positive policy rate, which
means excess liquidity through capital inflows must be absorbed by open
market operations, which reinforces exchange rate channel

Trade channel seems not so effective, as global trade sluggish since global
financial crisis

- Declining commodity prices, anemic growth in ADEs, weak global

investment, slowing expansion of global value chains, and limited progress
in trade liberalization (Arteta, Kose, Stocker and Taskin 2016)

III. Financial Stability Implications

1) Macroprudential Policies in Korea

2) Non-core Bank Liabilities and Credit Growth

3) Portfolio Investment and Long-term Interest Rates

1) Macroprudential Policies in Korea

For preemptively addressing financial imbalances in open EMEs, macroprudential

policy more desirable than monetary policy

- Financial cycles in open EMEs often driven by global liquidity conditions

- Tighter monetary policy to lean would only attract additional capital inflows

In aftermath of global financial crisis, Korea introduced diverse macroprudential

policy tools, to ensure that capital inflows through banks and bond markets
do not cause excessive procyclicality, and to avoid credit and housing bubbles

- Leverage cap on FX derivatives positions (introduced in 2010)

- Macroprudential stability levy on non-core foreign currency bank liabilities (2011)
- Taxation of foreigners bond investment gains (reinstated in 2011)
- LTV and DTI regulation on home mortgage lending (strengthened in 2009)
- Loan-to-deposit ratio regulation (reinstated in 2010)

1) Macroprudential Policies in Korea

Corporate Credit/GDP Household Credit/GDP

Sources: The Bank of Korea, BIS Sources: The Bank of Korea, BIS

Bank Non-core Liabilities/GDP Bank Short-term External Debt Ratio

Source: The Bank of Korea Source: The Bank of Korea

2) Non-core Bank Liabilities and Credit Growth

Hahm, Shin and Shin (2013a, b)

Non-core liabilities of banking sector can be regarded as a measure both

of stage of financial cycle, and of vulnerability to systemic risk spillovers

In open EMEs, stock of foreign currency liabilities of banking sector is an

indicator of excess liquidity and vulnerability to capital outflows driven by

In open EMEs, financial cycles could differ greatly from domestic business
cycles due to cross-border linkages through non-core funding

Non-core bank liabilities, especially foreign bank borrowings, are highly

procyclical and constitute important channel for transmission of global
liquidity shocks to Asian economies

2) Non-core Bank Liabilities and Credit Growth

Cho and Hahm (2014)

Macroprudential stability levy has significantly reduced non-core

foreign currency liabilities of Korean banks

Foreign Currency Deposits and Non-core Liabilities of Domestic Banks

(KRW, trillion) (%)

160 84
Deposit(left) NCLs (LHS)
NCL(left) FNCL ratio(right)
FNCL ratio (RHS)

80 72


0 60
'03 '04 '05 '06 '07 '08 '09 '10 '11 '12 13

2) Non-core Bank Liabilities and Credit Growth

Comparisons between actual and counterfactual non-core liability

ratios indicate a mean policy effect of -9.85%p

Actual and VAR-predicted Non-core Bank Liability Ratios

3) Portfolio Investment and Long-term Interest Rates

Yield Curve and Global Factors

While short-term interest rates under CBs control, long-term rates can
fluctuate substantially due to changes in term premiums triggered by bond
market flows undermining monetary policy autonomy in EMEs (Turner 2014)

Long-term interest rates and yield spreads have fallen substantially due to
compression of term premiums rather than to expected future short-term
Decomposition of Long-term Interest Rate1) Changes1) in Long-term Interest Rates2)
and Term Premiums
(%) (%p)
7 2
Treasury bond (10-yr) yields
6 10-yr Treasury bond yield (A+B)
Term premiums
5 1
Expected short-term rate (A)
3 0
<ADEs> <EMEs>
-1 Term premium (B)














07 08 09 10 11 12 13 14 15 16

Notes: 1) 10-yr Korea Treasury Bond Notes: 1) Changes from Jun. 2015 to Jul. 2016 2) 10-yr Korea Treasury Bond
Source: BOK staff estimates Sources: BOK staff estimates, Bloomberg

3) Portfolio Investment and Long-term Interest Rates

Global factors have far greater impacts, whereas role of domestic factors
diminished since global financial crisis

Fall in term premium driven by real risk premium, due to expanded foreign
investor preferences for Korea Treasury bonds as safe asset

Estimates of Factors Determining Yield Spread Foreign Investors Treasury Bond Balance
Yield Spread Historical Decomposition1)2) and Duration1)
(%p) (trillion won) (years)
3 75 4.0
Domestic Yield Real economic shocks Bond holding balance (LHS)
Spread (yt) Monetary shocks Duration (RHS)
Overseas shocks 70
2000~07 2010-16 2 3.5
Long & short-term yield spread (compared to trend)

yt-1 0.56*** 0.42*** 65

1 3.0
Call Ratet1) -0.52** -0.29***
Nominal GDP Growth t 0.11** 0.06*
0 2.5
Global Factorst2) 0.03 0.16*** 55

Constant Term 1.77** 0.75***

-1 50 2.0
R2 0.82 0.97 00 02 04 06 08 10 12 14 16 14.1 14.7 15.1 15.7 16.1 16.7

Notes: 1) Overnight rate basis Notes: 1) 4-variable VAR model including yield spread, Note: 1) Based on total won-denominated bonds held by
2) First common factor of yield spread among 14 call rate, GDP gap ratio and global factors foreign investors
advanced economies (Principal Component 2) Real , monetary and overseas shocks included Source: Yonhap Infomax
Analysis) in GDP gap ratio, call rate and global factors,
Source: BOK staff estimates respectively
Source: BOK staff estimates
3) Portfolio Investment and Long-term Interest Rates

Compressed term premium and flattened yield curve undermine financial

intermediation for productive uses of financial resources, and encourage risk
taking by financial institutions

Easy financing conditions due to low long-term market rates cause increased
household leverage, and may create asset and housing market boom-bust

Life Insurers Risky Assets1) Household Debt and Interest Rate1)

(trillion won) (%) (trillion won) (%)
250 50 1,500 10

Volume of risky assets (LHS) Household debt (LHS) Interest rate (RHS)
Proportion of risky assets (RHS) 45
200 8
150 6
35 900
100 4
50 2

0 20 300 0
2007 2010 2013 Q1 2016 07 08 09 10 11 12 13 14 15 16
Note: 1) Assets containing risk-weights of 50% or higher, such as loans, Note: 1) Weighted average of depository institution interest rates on
stocks and corporate bonds loans to households; newly extended basis
Source: Financial institutions business reports Source: The Bank of Korea

3) Portfolio Investment and Long-term Interest Rates

Channels of Transmission of Low Interest Rate Effects to Financial Markets

Strengthening of Search for yield

Low interest
Strengthening of risk taking (underestimating risk)

Capital Financial investment

Money markets Asset markets
markets product markets
Accumulation of

financial system
imbalances in

Increased fund inflows to marketable

Increased financial products with uncertain returns Increased fund
fund inflows inflows to
to stock & housing & real
sub-prime Investment funds estate markets,
bond markets Structured notes etc.
ABCP, etc.
Retail RPs, etc.

Interest rate Strengthening of risk aversion (rapid risk reappraisal)

increase /
Domestic or
external shocks Surging fund outflows from risky asset markets Financial market instability

Source: Financial Stability Report (BOK, June 2016)

3) Portfolio Investment and Long-term Interest Rates
Long-term Rates Rising Significantly since US Presidential Election
Long-term interest rates have risen significantly, affected by increases in US
market rates since
L US presidential election
o rates likely to continue showing high volatility, affected
Long-term interest
largely by US interest rate movements in line with Trump administrations
policy changes, as
g well as expectations of US Fed monetary policy
Yield Curve Treasury Bond (10-yr) Yield Korea and US Treasury Bond Yields
t Changes <since presidential election>
(%) (bp) (bp) (%)
50 2.8 2.8
Change from Nov. 1 to 28 (RHS)
Korean Treasury (3-yr, LHS)
Oct. 31, 2016 (LHS) Korean Treasury (10-yr, RHS)
Nov. 28, 2016 (LHS) r 50
40 2.5 US Treasury (10-yr, RHS) 2.31%

30 2.2 2.2
1.8 30 2.15%
43 46 48 48
20 1.9 1.9
I 20
10 1.6 1.6
1.4 23
n 10

3M 1Y 2Y 3Y 5Y t
10Y 30Y
0 0
Nov. 1 7 10 15 18 23 28

Source: KOFIA
e Note: 1) Changes from Nov. 10 to 28 for Asian
countries, and from Nov. 9 to 28 for
US and European countries
Sources: KOFIA, Bloomberg

r Sources: KOFIA, Bloomberg


IV. Policy Lessons and Conclusion

Prolonged period of unconventional monetary policies in ADEs has led to

exchange rate appreciation and overly compressed term premium of long-
term interest rates in Korea, without significant effect in boosting external
demand for exports

- UMPs have not contributed much to real GDP growth, as trade channel
substantially weakened since global financial crisis

- On other hand, currency appreciation has put significant downward

pressure on inflation

- While aggregate demand effects of low long-term interest rates and

currency appreciation are uncertain, both have brought about lax
financial conditions

Central bank has faced difficult tradeoffs between price stability and
financial stability

- Accommodative monetary policies to address disinflationary pressure

may increase financial stability risks
IV. Policy Lessons and Conclusion

Macroprudential policies could be useful first line of defense to cope with tradeoffs,
but difficult to address every channel of potential spillover

- Korea has constrained rapid bank credit growth and currency mismatches driven
by non-core foreign currency bank financing
- However, bond market flows and long-term interest rates have been significant
channels of cross-border spillover, leading to higher financial stability risks and
less monetary policy autonomy
- May need more active debt management policies to cope with volatilities,
but with risk of weaker fiscal discipline

Essential to conduct macroprudential and monetary policies in harmonized and

complementary manner, and to also consider financial stability risks in formulating
monetary policy strategies

- Establish effective and transparent macroprudential policy governance scheme

- Monetary policy could in part internalize financial stability concerns
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