Seoul mulls cap controls if QE2 exceeds expectations

The country’s government is on high alert over fears that the Federal Reserve will fill the market with US dollars and lead to hot money inflows. But Seoul is only likely to introduce capital control options if the Fed’s money printing exceeds expectations, says RBS.

  • 22 Oct 2010
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Korea looks set to only impose capital controls if the quantitative easing measures of the US Federal Reserve exceeds market expectations, believes Erik Lueth, senior regional economist at Royal Bank of Scotland (RBS).

His views closely follow public comments made by the country’s vice finance minister Yim Jong Yong that Seoul is looking at a number of capital control options available to it, in order to limit the inflow of foreign currency that is placing appreciation pressure on the Korean won.

Lueth says that foreign investment hurdles would only be introduced in the event that the Fed’s quantitative easing surprises everyone on the upside. Market expectations for the Fed’s second round of quantitative easing is somewhere in the region of US$1 trillion.

Seoul’s fear is that if such easing leads to amounts more than this amount it could lead to hot money making its way into South Korea, placing further pressure on the won to rise. The currency has already strengthened from W1,152.34 against the US dollar at the beginning of the year to W1,128.03 today (October 22).

The matter is not just an issue of economics. Korea’s politicians are keen to be seen to look after the country’s best interests.

“There is a lot of political pressure, including at the parliamentary hearings recently, and a number of politicians threatened to go it alone,” Lueth said in a research note.

The big question is what form such controls would take if introduced. It is understood that a number of possibilities have been considered but that discussions are at a relatively early stage.

They include: further capping of banks’ derivatives positions; taxing foreign inflows applying to a number of assets; a bond withholding tax; and a Tobin tax on all FX transactions and unremunerated reserve requirements.

In the case of lowering the ceiling of banks’ derivatives positions, the measure would be adopted to prevent to rampant use of foreign exchange forward purchases made on the back of carry trades. However Lueth said in his report that this may not have the desired effect.

“It is ineffective to the extent that foreign banks and their customers are willing to take unhedged positions on the won... it is also ineffective in slowing down portfolio bond inflows,” he said.

Introducing a tax on capital inflows, similar to what Brazil has done, would also be difficult for Seoul to do. To begin with the government would need the consent of Korea’s parliament to pursue such a move. Additionally such tax might contravene Organisation for Economic, Co-operation and Development (OECD) rules, making its introduction unlikely.

“This pretty much rules out an OECD country like Korea,” Lueth said.

  • 22 Oct 2010

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