The purpose of this study is to discuss about the economic and financial integration after the reunification of North and South Korea. The discussion mainly focuses on the financial policy tasks and responses the two Koreas should take, presupposing the North Korea’s economic situation at the final stage of the interim separated operation period. The more the economic situations of North and South Korea differ, the higher the cost would be for the integration; because the shock to the two economies will be so asymmetric that policy measures could hardly be unified. Moreover, the use of single currency may cause economic instability and generate loss, since both Koreas will not be able to use the currency that best reflects their own economy and have to abandon the autonomy of monetary policy. Then yet, oppositely remarking: the more the economic situations of the two Koreas resemble, the greater the benefits are from the economic integration and single currency use. Thus, as Optimum Currency Area (OCA) theory suggests, the proper time to terminate the interim separated operation is when the economic similarity of the two Koreas surpasses the threshold where gains and losses from integration coincide.
In this paper, I propose policy directions and tasks for monetary and exchange rate policies in the period of integration, including the exchange rate policy, monetary policy operation, security of external soundness and foreign exchange prudential, and safeguards against crisis. Looking into detail, the exchange rate of North and South Korea’s currency will be decided upon the arbitrage rate at the termination of the separated operation; however, adjustments should be made considering the economic gap between the two economies as well as their market situations. And in the end, the rate should follow the floating exchange rate system. As for the monetary policy operation, the Bank of Korea should overhaul the correct functioning of the policy paths by taking charge of both economies and use open market operation to set the base rate in a bid to achieve price and financial stability.
In order to manage the macroprudential risks in the process of integration, it is necessary to strengthen the foreign reserves considering the foreign debt level of North Korea, foreign currency outflow due to integration, and the second-tier foreign reserves. At the same time, we need to keep a keen eye on the moral hazards of financial companies and possibility of deepening risks. As for regulating the foreign exchange soundness of financial institutions, the authorities should impose stricter foreign currency LCR regulations to South Korean banks and non-financial institutions. In case of North Korean financial firms, we need to take a more careful approach in consideration of their financial standings and local economic situation. And since financial market instability and mass capital outflows, resulting from the North Korean financial companies’ insolvency and lack of capital adequacy, may occur at any time during the period of integration, safeguards such as the capital transaction permitting system should also be established.
In regard of the financial industry integration, I first review the basic policy direction, regulatory supervision system, and regulation method; then discuss about the main policy tasks and responses regarding the financial market and corporate restructuring, policy finance, small loans, and financial consumer protection. The basic policy direction aims to provide efficient financial intermediary services and real support in response to new environmental changes, while building an environment that could effectively overcome potential risks and accumulate financial assets internally. In order to do that, the following should be accompanied: the improvement of regulatory supervision system, internal change by financial businesses, liquidation of insolvent corporates, frameworks for restructuring, and revision of policy financing system. In particular, given that economic participants of North Korea do not have much experience in financial services consumption, policies should concentrate in enhancing the financial accessibility and improving the financial consumer protection.
No one can be so sure of the economic and financial situation of the two Koreas at the terminating moment of the separated operation. Therefore, the key to the economic integration is to maintain fiscal soundness while eliminating the difference in financial structure between the two Koreas and strengthening the local autonomy. This is also in line with the vision of Decentralization Roadmap as well as that of the federal system, which is currently being pursued for the local autonomy in South Korea. In order to build a comprehensive system for fiscal decentralization and local finance which not only well reflects the regional uniqueness and diversity but also well balances autonomy and responsibility, we need to integrate financial systems, such as taxation and tax administration, and secure financial stability by regulating the public expenditures.
The local finance system should be operated in a way to give practical support to the local government, not to regulate or control it. This can be accomplished through raising the predictability of local administration; so the central government should induce the local governments to prearrange the financial adjustments plans. Moreover, taking into account the change in public expenditure structure and tax environment, such as social overhead capital investments and social security budgets, we also need disciplinary devices to control the fiscal deficits of North Korea and crisis resolution mechanisms. In case the financial situation of North Korea deteriorates, the central government should shore up funds to improve financial conditions, and there should be disciplines and interventions to reduce fiscal deficits or achieve fiscal balance. Thus, it is necessary to develop guidelines for fiscal rules and financial autonomy of local governments, in relation to financial crisis prevention and crisis intervention.