Financial instability and debt flows

into South Korea

EC331: Research in Applied Economics
Dustin Haliman
Background and Motivation
Historically, bubbles that eventually lead to crisis in EMEs can
trace their origins to a period of excessive capital inflows (capital
surges). These very capital inflows have lead to exuberance fueled
(mismanaged) credit booms and busts in the region.
I seek to investigate, theoretically and empirically, the
transmission mechanism between debt flows and the real
economy. This has not been thoroughly investigated in existing
literature.
In particular, I am interested in seeing whether speculative
(short-term) debt flows truly pose a threat to the real economy
through its effect on overall leverage levels and hence financial
instability. Hopefully, my findings can provide insight into
assessing crisis risk.
Econometric Approach
Multiple regression using time-series.
Tested each variable for non-stationarity using ADF test. All
series were found to non-stationary and I(1). First difference
solved issue.
Tested for cointegration between variables. No cointegrating
relationships found.
Built model in differences using general to specific approach.
– I generously added lags of dependent and independent variables and
‘tested down’ (i.e. removing lags) based on individual significance.
Final model has no-serial correlation, allowing consistent
interpretation of coefficients.
Model
South Korea between Q4 1994 – Q3 2015.
Dependent variable: Δ External Debt Stock as % of GDP (to
reflect leverage levels)
Regressors (with lags):
– Δ External Debt Stock % of GDP
– Long-term government debt flows.
– Both short-term and long-term central bank debt flows.
– Both short-term and long-term bank (depository institution) debt flows.
– Multiplicative dummies (inflow as default) for both short-term and long-
term bank debt flows.
– Both short-term and long-term direct debt flows into firms.
Note that differences in stock is equivalent to flows.
Theory
External debt, like domestic debt, has two main end
(investment) uses in an economy:
– Long-term: investment into fixed capital (i.e. machinery, improving
productivity). This increases GDP in the long-run.
– Short-term: covering working capital1 needs and/or temporary variable
costs. This does not contribute to GDP growth in the long-run.
How the debt actually transmits into investment/spending can
occur directly or indirectly.
Directly: foreign lending goes directly to firms without passing through a
mediating institution.
Indirectly: debt is first borrowed by a bank, before being ‘re-lent’ to
domestic firms. 2
For this presentation, focus will be on direct and indirect.

1. From a practical perspective working capital is used to buy assets or pay for obligations.
2. Recall how banks make money, usually borrow short (deposits) and lend long.
Theory: Indirect Loan
When a loan is indirect (whether short-term or long-term) it is
usually ‘re-lent’ long-term by the bank. Long-term loans = long-
term investments.
During periods of inflows, both short-term and long-term flows
will have a positive same-period effect on growth in debt/gdp.
As newly received debt gets re-lent and re-invested, GDP will
grow and there will be lagged negative effects on growth in
debt/gdp.
During periods of outflows, of both short-term and long-term
debt, bank credit falls and investment decreases. The
immediate same-period effect on debt/gdp is ambiguous as
both debt and gdp fall. Lagged effects are also ambiguous,
though reduction in investment may outlive initial outflows.
Theory: Direct Loan
When a loan is direct, the length of the debt will be identical to
the length of the investment (short-term loan -> short-term
investment).
Since short-term loans = short-term investments, one can
expect that this type of debt flows will only cause a same-period
increase in the growth of debt/gdp.
– There will be no offsetting future growth in GDP (as a result of
investments) to reduce changes in debt/gdp.
Long-term loans, on the other hand, will also cause a same-
period increase in the growth of debt/gdp.
– However will be offsetting future growth in GDP being driven by
productive investments. Hence future debt/gdp growth can be expected
to decrease.
Regression Results
Flows are in trillion
won. Today, one trillion
won is equivalent to
USD$820+ million.
What’s the big-deal?
Inflows / outflows can
vary in the tens of
trillions of won per
quarter.
Breusch Godfrey:
χ2=7.451
Prob > χ2 = 0.1139
No serial correlation
 Interpretation
Direct channel:
Short-term flows only have same-period positive effect.
Long-term flows have initial same-period positive effect but
offsetting one lag negative effect.
Indirect channel:
During period of inflows, both short-term and long-term flows
have a same period positive effect, with negative lagged effects.
During period of outflows, only short-term flows seem to have a
(overall) same-period positive effect (0.1275) and lagged positive
effects apart from the first lag: -0.0895, 0.0115, 0.2171.
No distinction between effects of long-term flows during inflows
and outflows.
Conclusion and Further Comments
The empirical findings seem to agree with the theory proposed.
Short-term flows, more so than long-term flows, seem to
predominantly increase debt/gdp without any offsetting effects
over time.
Further steps:
– We discussed dynamic effects in this presentation. More needs to be done
in the interpretation of cumulative effects.
– Potentially investigate whether significant differences arise if we try to
distinguish flow effects when debt/gdp is rising and when it is falling. Use
multiplicative dummy variables.
Main limitations: 1) regression was done in differences, which
doesn’t contain much long-run information, 2) Interpretation of
the coefficients is limited.