This study analyzes the relationship between cross-border capital flows and the foreign exchange market in Korea. It aims to propose revisions to the Foreign Exchange Transaction Act to facilitate international transactions and maintain external financial stability in light of changing macroeconomic and financial market environments.

The foreign exchange system is shaped by historical contexts, typically introduced to minimize the negative impact of currency fluctuations during events such as economic recessions or wars. However, as economies develop and financial markets grow, there is an increasing demand for the relaxation of regulatory measures on foreign exchange transactions.

As an open economy highly dependent on external trade, Korea encounters considerable risks to its economic stability from rapid fluctuations in exchange rates. Therefore, understanding the relationship among cross-border capital flows, interest rates, and exchange rates is crucial in crafting an effective foreign exchange system. Despite the projected increase in fiscal spending to address the aging population and enhance the quality of life, Korea's overall savings are expected to grow for the time being. With the domestic potential growth rate declining, it seems that the demand for private external financial investments will persist, indicating an expected increase in cross-border capital movements. The growth in private external financial investments presents an opportunity to ease regulations in the foreign exchange market, as the private sector can serve as an automatic stabilizer against exchange rate volatility by actively participating in the foreign exchange market and restoring normal rates.

Chapter 2 examines the impact of increasing domestic and international capital flows on Korea's financial markets. Analyzing the effects of foreign capital inflows using the Flows Implied by Rebalancing (FIR) index (Pandolfi & Williams, 2019), this chapter indicates that global passive fund inflows are associated with significant increases in bond prices (lower interest rates) and a strengthening of the Korean won (weaker exchange rate). These effects are more pronounced for non-reserve currency emerging market countries like Korea. Furthermore, the study investigates the impact of domestic funds' overseas investments on the foreign exchange market. It uses a synthetic control method to assess the effects of the 2017 policy that recognizes asset duration irrespective of insurance companies’ hedging practices. The findings show that an increase in domestic securities investments abroad leads to a decrease in the real effective exchange rate, resulting in a depreciation of the Korean won. However, there is no evidence that excessive demand in the foreign exchange market rises as swap rates increase, suggesting Korea’s foreign exchange market has gained stability compared to the past. An examination of the correlation between the won-dollar exchange rate volatility and the amount of net foreign assets reveals that more recently, as net foreign assets increase and the ratio of won-denominated liabilities rises, the amplitude of the net foreign asset increase due to non-trading factors tends to rise when the won depreciates, indicating the operation of an automatic stabilizer.

Chapter 3 puts forth the direction and key policy recommendations for the revision of the Foreign Exchange Transaction Act. The focus is on enhancing the efficiency of foreign exchange transactions while pursuing external stability. It suggests recognizing the Foreign Exchange Transaction Act more as a trading law than a business law, aiming to reduce overlaps with individual financial laws arising from its business law characteristics.

More specifically, Chapter 3 explores the history of Korea’s foreign exchange management policies and analyzes their characteristics and problems. Initially designed to curb the outflow of foreign exchange, these policies have since transformed to liberalize foreign exchange transactions across both current and capital accounts. However, the foreign exchange authority has maintained a conservative stance, prioritizing external soundness. Notably, the Foreign Exchange Transaction Act is recognized as a business law, maintaining a bank-centric approach while regulating the foreign exchange operations of non-banking financial institutions. Furthermore, the Act adopts a listing and delegation legislative approach. As a result, the current law is not only vulnerable to changes in the external environment but also faces issues of low legal systematicity, leading to high compliance costs.

Currently, most developed nations operate without legal restrictions on foreign exchange transactions. Countries that initially introduced regulations as a response to economic crises or wars have either eliminated or considerably eased these regulations to improve national competitiveness and foster the growth of their financial industry. Japan, whose foreign exchange system has historically resembled Korea’s, opened up foreign exchange operations to non-banking financial institutions and even non-financial companies as part of its financial big bang in 1998. However, Japan has retained a regulatory role in terms of information collection and monitoring for foreign exchange transactions. It continues to inspect and supervise foreign exchange operations of individual financial institutions under the applicable financial industry laws or laws governing financial product transactions.

This study proposes revisions to Korea’s Foreign Exchange Transaction Act based on international case studies. First, the Foreign Exchange Transaction Act, presently skewed towards business law characteristics, should shift its focus to underscore its role as a trading law rather than a business law. To invigorate foreign exchange transactions, the Korean government should move away from classifying foreign exchange operations as regulatory subjects and instead strengthen the monitoring and reporting systems for transactions. It is advisable to delegate regulation of foreign exchange operations to financial authorities under individual financial industry laws, with the Foreign Exchange Transaction Act stepping in only where foreign exchange operations are not covered under the relevant financial industry laws.

Second, this study recommends transitioning the regulatory approach for foreign exchange transactions under the Foreign Exchange Transaction Act from institutional to functional regulation. Functional regulation involves categorizing operations by their function and applying consistent regulations to identical activities, laying the groundwork for adapting to future changes, such as the digital transformation of finances.

Third, in response to the relaxation of foreign exchange regulations, the study suggests reinforcing liquidity and soundness for non-bank financial institutions. This compensatory measure addresses concerns associated with the shift toward functional regulation, which might essentially eliminate bank-centric practices, posing potential risks to financial stability due to the risk-taking practices of non-banking financial institutions. Specific measures include applying foreign exchange liquidity coverage ratio (LCR) requirements for financial investment firms, enhancing the effectiveness of Net Operation Capital Ratio (NCR) regulations, strengthening the responsibilities of boards and CEOs as licensing conditions for foreign exchange operations, and ensuring continuous supervision and inspections post-authorization. This approach mitigates concerns about functional regulations compromising external soundness by adopting a ‘same taskssame riskssame regulations’ rule at the financial regulatory and supervisory level to respond to systemic risks.

Finally, the study proposes imposing prompt corrective action measures on financial institutions handling foreign exchange transactions to enhance the effectiveness of safeguards before emergencies arise. Corresponding to the extent of regulation relaxation on foreign exchange operations, the Korean government strengthens the liquidity and soundness of financial institutions engaged in foreign exchange operations by enforcing prompt corrective action when various regulatory ratios are exceeded. Such measures not only minimize the broader systemic impact in case of early-stage insolvency but also incentivize companies to uphold sound management practices.

While Korea's foreign exchange system has evolved to reflect changes over time, the pace of these changes has been notably slow. While Korea actively engages with the international community, its efforts to liberalize foreign exchange transactions are constrained as a non-key currency nation. Nevertheless, the need for reform in the current conservative foreign exchange system persists for the sake of economic and capital market development.

Despite Korea’s orientation toward an open economy, its view on openness has traditionally centered around trade. From the early stages of economic development, exports have served as the primary engine of Korea’s economic growth, leading to minimal regulations on current account transactions. Consequently, foreign exchange transactions related to current account activities have been freely permitted. On the contrary, foreign exchange transactions for capital account activities have faced stringent regulations. While strict control over foreign exchange transactions might initially boost financial stability, it could also lower overall economic efficiency and potentially decelerate economic growth. Furthermore, ensuring financial stability requires collaborative efforts and coordinated actions among monetary, fiscal, financial, and financial supervisory authorities to enhance the stability of the financial system.

In conclusion, the study advocates for a significant easing of the regulations on foreign exchange transactions in Korea, recommending adjustments to match the current economic conditions and national competitiveness strategy. Korea’s financial institutions are positioned to lead the development of the financial system, especially as global portfolio diversification emerges as an economically efficient choice. This shift is happening against a backdrop of declining potential growth rates and rising demand for both domestic capital investments abroad and foreign capital investments within Korea. Therefore, it is imperative for the Korean government to comprehensively reassess restrictive regulations that hinder the global expansion of financial institutions, with the restrictions imposed by the Foreign Exchange Transaction Act as a prime example of such regulation in need of thorough reevaluation.

Preface
Executive Summary

Chapter 1 Introduction (Dongsoo Kang)
　Section 1 Changes in the Economic Environment and the Foreign Exchange System
　Section 2 Changes in Macroeconomy and Financial Markets
　Chapter 3 Contents of Each Chapter
　References

Chapter 2: The Impact of Domestic and Foreign Capital Flows on Financial Markets (Meeroo Kim&Jongsoo Hong)
　Section 1 Introduction
　Section 2 Factors of Global Capital Flows
　Section 3 Existing Research and Literature Review
　Section 4 Methodology of Empirical Analysis
　Section 5 Basic Statistics (FIR)
　Section 6 Empirical Results
　Section 7 Conclusion
　References
　Appendix


Chapter 3: Recommendations for the Revision of the Foreign Exchange Transaction Act (Dongsoo Kang)
　Section 1 Introduction
　Section 2 Foreign Exchange Laws in Korea
　Section 3 The Case of Japan's Foreign Exchange System
　Section 4 Reform Direction of Korea's Foreign Exchange System
　Section 5 Conclusion
　References
　Appendix

Chapter 4 Concluding Remarks (Dongsoo Kang)

ABSTRACT