Since a global financial market and its potential volatility pose such a grave potential danger for most emerging economies, individual countries and the international community should find ways and build mechanisms, by which the systemic risk of global financial instability could be minimized. Most of all, at the national level, the old question on how market opening should be sequenced may need re-examination in a new perspective. The old wisdom holds that properly and orderly sequenced external liberalization should be from the current account to the capital account and capital account liberalization should be in the order of long-term to short-term. However, after the recent crisis, heated debates are not on how to get the sequencing right, but on how to deal with the volatility of short-term capital flows.
In fact, there are often-heard voices advocating temporary controls over capital inflows a la Chilean scheme, which should be introduced before a crisis occurs, or controls over capital outflows, a la Malaysian way, which should be applied after crisis arises especially if a country is in the transition period of strengthening the institutional and regulatory domestic financial institutions. At the same time, the argument for an enhanced disclosure requirement and changes in current bank lending procedures to hedge funds is also gaining force. Maybe, we had better get ready to see more emerging markets trying various mechanisms for controlling short-term capital inflows, including hedge funds, on the other hand and fostering long-term capital inflows, such as foreign direct investment, on the other hand.

This development of policy interests suggests that the question on sequencing should be dealt with in a rather broadened scope. Indeed, the main purpose of this paper is to argue that the scope should go beyond mere contemplation on carriers of capital flows and comprise considerations on incentives of domestic and international agents who make use of those carriers.

The most serious sequencing problem in Korea was to liberalize short-term financing through banks rather than long-term financing, and to underestimate the potential devastating impact on the economy when massive capital inflows have come to reverse. Although long-term capital inflows were rather repressed during the pre-crisis period, it would be an exaggeration to say that short-term capital movements were liberalized greatly. Neither firms nor banks could sell their short-term debt instruments in domestic currency to foreigners. Only liberalized were trade-related financing of firms and short-term foreign currency borrowings of banks.

The intention was clear: liberalize first capital flows that are only trade related. Then, how about short-term foreign currency borrowings of banks? Should the Korea government have restricted short-term borrowings of banks? Probably the answer is No. It is extremely costly to control short-term transactions of banks. What was lacking was financial supervision and appropriate risk management. Without strengthening banking supervision and enhancing corporate governance, corporate debt crisis will be an inevitable outcome. In this regard, the main lesson of the Korean crisis is not the sequencing problem in the capital market liberalization, but the structural deficiencies as prerequisites of capital market liberalization.

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Executive Summary

Ⅰ. Introduction

Ⅱ. Capital Account Liberalization in Korea
A. Liberalization in 1980s
B. Liberalization in 1990s
C. Capital Inflows in 1990s
D. What went wrong?
E. Causes of Liquidity Imbalances or Short-termness

Ⅲ. Lessons
A. Strengthening Prudential Regulation and Supervision
B. Strengthening Corporate Governance
C. Promoting Foreign Direct Investment
D. Orderly Liberalization: How to Sequence the Capital Market Opening?

Ⅳ. Postscript

Appendix

References

Korean Abstract