Gwang-Ju Rhee Deputy Governor

Challenges Facing Central Bank in Conducting Monetary Operations under Excess Liquidity(the Case in the Korean Economy)

Gwang-Ju RheeDeputy Governor

2007 BANK INDONESIA WORKSHOP (session 2)

BANK INDONESIA WORKSHOP on Developing Government Bond Market :The Challenges towards a Sound Monetary Management

Contents

I. Monetary Policy Framework and Liquidity Management

1. Current Monetary Policy Framework2. Instruments of Liquidity Management3. Balance of Payments Surplus and Liquidity

Management4. Measures to Improve Liquidity Management

II. Assessment of Current Market Liquidity Conditions and Policy Responses

1. Assessment of Market Liquidity Conditions2. Policy Responses



□ In the process of recovering from the Financial Crisis, the BOK adopted an Inflation Targeting system, in which its emphasis on monetary policy implementation shifted from the monetary aggregates to interest rates.

– Overnight(O/N) Call Rate set as operational target

□ In managing money market liquidity, the BOK focuses on achieving its call rate target.

– Market liquidity indices, including the monetary aggregates (eg. M2, M3), are used as some of the major information variables in conducting monetary policy.

1. Current Monetary Policy Framework


2. Instruments of Liquidity Management

□ The BOK manages liquidity through open market operations.

□ The tools for open market operations are repos and monetary stabilization bonds (MSBs).

– Repos: short-term regulation of liquidity conditions• Maturity: 1 ~ 14 days

– MSBs: adjustment of fundamental liquidity conditions• Maturity: 14 days ~ 2 years * Composition (currently as of end of Sept.): 2-year (79.3%), others (20.7%)



□ The BOK manages liquidity by absorbing or providing reserve money to banks.

– Due to the relatively high reserve requirement ratio, the ratio of the reserve requirement volume relative to total settlement volume exceeds those in the US and the Euro region.

US Euro

Region UK Korea

0.13 7.46 6.20 19.73

Ratio of Reserve Requirement to Settlement Volumes (%)



3. Balance of Payments Surplus and Liquidity Management

□ Due to the continued current account surplus and capital inflows, pressures for excess liquidity have increased.

- 30

- 20

- 10

0

10

20

30

40

50

1990 1992 1994 1996 1998 2000 2002 2004 2006

(billion dollars)

Capital Account

Current Account

Trends of Current and Capital Accounts



□ Pressures for excess liquidity has been absorbed through issuing MSBs.– Currently, as of the end of Sep. 2007, the amount of MSBs in circulation

stands at 151.2 trillion won (164.87 billion dollars).

Balance of Payments* and MSB Trends

0

10

20

30

40

1999 2000 2001 2002 2003 2004 2005 2006

0

20

40

60

80

100

120

140

160

180(billion dollars)

BOP (Left)

Net issuance of MSBs (Left)

Balance of MSBs (Right) (billion dollars)

* Current account + capital account



3. Balance of Payments Surplus and Liquidity Management

□ The BOK has taken measures to address the increased refinancing burdens caused by MSBs, as follows:

– CRS deals with the National Pension Service funds and commercial banks

• Introduced in May 2005 (balance $19 billion as of end Sep. 2007

– Reserve requirement ratio adjustment (Nov. 2006)

• Average ratio : 3.0% 3.8%



□ The government has encouraged overseas investment by Korean citizens.

– Limits on overseas real estate acquisition for investment purposes adjusted upward

– Temporary tax exemption on capital gains from overseas stock investment

□ Restraints on short-term overseas borrowing



4. Measures to Improve Liquidity Management

□ In conducting monetary policy using the call rate target, the following problems occurred:

– The call rate (being almost fixed at its target level, with its market price function greatly restricted) failed to reflect short-term liquidity supply and demand conditions.

– Short-term capital transactions became concentrated in the O/N call market, undermining development of the money markets for maturities longer than two days.



□ The BOK is arranging measures to enhance the effectiveness of its liquidity management:

① Shifting of BOK policy rate from Call Rate to “Official Bank Rate (7-day RP rate)”

② Regularization of Open Market Operations

• OMOs will be mainly conducted once a week, through transactions in RPs with one-week maturity.

③ Introduction of standing facilities



II. Assessment of Current Market Liquidity Conditions and Policy Responses

□ The BOK manages money market liquidity to achieve the call rate target, while utilizing financial market gross liquidity as one of its major indicators in conducting monetary policy.

– Focusing on the fact that inflation is a monetary phenomenon in the mid- and long-term

1. Assessment of Market Conditions


□ The growth of market liquidity (eg. M2, Lf) has exceeded that of nominal GDP growth since 2005.

Market liquidity evaluated as abundant relative to real economic activities

- 3

- 1

1

3

5

7

2000 2001 2002 2003 2004 2005 2006 2007

(%)2007.2nd Q.

5.6%

M2, Lf & Nominal GDP Growth

II. Assessment of Market Liquidity Conditions and Policy Responses

Money Gap Ratio

0

2

4

6

8

10

12

14

16

2000 2001 2002 2003 2004 2005 2006 2007

Nominal GDP growth

Lf growth M2 growth

(%)


2. Policy Responses

□ The BOK has been concerned that continued high growth of market liquidity might cause inflation and asset price bubble

The BOK has raised the call rate target 7 times since Oct. 2005, from 3.25% to 5.0%.

3

3.5

4

4.5

5

5.5

1999 2000 2001 2002 2003 2004 2005 2006 2007

(5.6)

( %)

(2.10)(10.5) (2.8)

(7.5)

(8.9)

(9.19)(5.7) (5.13)

(7.10)(8.12)

(11.11)(10.11)

(12.8)(2.9)

(6.8)

(7.12)

(8.9)

(8.10)

Call Rate Target Trends

II. Assessment of Market Liquidity Conditions and Policy Responses

Gwang-Ju Rhee Deputy Governor

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