Gwang-Ju Rhee Deputy Governor

1. 2007 BANK INDONESIA WORKSHOP (session 2) Challenges Facing Central Bank in Conducting Monetary Operations under Excess Liquidity(the Case in the Korean Economy) Gwang-Ju Rhee Deputy Governor

2. Contents • Monetary Policy Framework and Liquidity Management • Current Monetary Policy Framework • Instruments of Liquidity Management • Balance of Payments Surplus and Liquidity Management • Measures to Improve Liquidity Management • Assessment of Current Market Liquidity Conditions and Policy Responses • Assessment of Market Liquidity Conditions • Policy Responses

3. I. Monetary Policy Framework and Liquidity Management • Current Monetary Policy Framework • 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.

4. Monetary Policy Framework and Liquidity Management 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 e nd of Sept.): 2-year (79.3%), others (20.7%)

5. Monetary Policy Framework and Liquidity Management • 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. 주요국의 지준규모/결제규모 비율 (%) Ratio of Reserve Requirement to Settlement Volumes (%)

6. Monetary Policy Framework and Liquidity Management 3. Balance of Payments Surplus and Liquidity Management • Due to the continued current account surplus and capital inflows, pressures for excess liquidity have increased. Trends of Current and Capital Accounts

7. Monetary Policy Framework and Liquidity Management • 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 * Current account + capital account

8. Monetary Policy Framework and Liquidity Management 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%

9. Monetary Policy Framework and Liquidity Management • 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

10. Monetary Policy Framework and Liquidity Management 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.

11. Monetary Policy Framework and Liquidity Management • The BOK is arranging measures to enhance the effectiveness of its liquidity management: • Shifting of BOK policy rate from Call Rate to “Official Bank Rate (7-day RP rate)” • Regularization of Open Market Operations • OMOs will be mainly conducted once a week, through transactions in RPs with one-week maturity. • Introduction of standing facilities

12. 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

13. II. Assessment of Market Liquidity Conditions and Policy Responses • 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 M2, Lf & Nominal GDP Growth Money Gap Ratio

14. 2. Policy Responses II. Assessment of Market Liquidity Conditions and 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%. Call Rate Target Trends