KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Policy Study KOR The Role of Invoicing Currency in International Trade: Determinants and Implications

This study examines the determinants of invoicing currency choice in South Korea’s international trade and analyzes how exchange rates affect trade outcomes across invoicing currencies. Using Korean product-level customs data, it documents distinctive patterns in Korea’s invoicing currency composition and identifies key factors shaping firm-level currency choices for exports.

These factors include the invoicing currency composition of imported intermediate goods, firm-level foreign-currency debt ratios, past invoicing practices, export market share, foreign exchange market size, invoicing currencies of competitors, and exchange rate volatility.

The results show that the degree of exchange rate pass-through varies significantly by invoicing currency, leading to meaningful differences in export volumes. Building on these findings, the study investigates the impact of recent exchange rate movements on Korea’s exports and demonstrates that the dominance of the U.S. dollar as invoicing currency imposes significant constraints on Korean export performance.

This study provides an updated and comprehensive overview of Korea’s invoicing currency patterns in trade, offering rich implications regarding the determinants and consequences of invoicing currency choice. The findings are expected to inform ongoing policy discussions on the revision of the Foreign Exchange Transactions Act, the internationalization of the Korean won, and broader initiatives aimed at advancing Korea’s foreign exchange market.

Summary

Research Monograph KOR Monetary Policy Transmission to the Korean Bond Market

This study quantitatively examines the transmission channels through which domestic and external monetary policy shocks affect the yields of Korean Treasury Bonds (KTBs). To this end, it proposes a new methodology that decomposes long-term KTB yields into expected policy rate paths and term premia and analyzes the interaction between monetary policy and the government bond market through this decomposition. Specifically, the study develops and estimates a four-factor linear term structure model that incorporates gradual structural changes in the level of the KTB yield curve. A comparison with the conventional three-factor model shows that the proposed four-factor model is statistically superior.

The estimation results indicate that, when yields are decomposed into trend and cyclical components, cyclical fluctuations account for a larger share of yield variation at shorter maturities, whereas trend components dominate at longer maturities. The expected policy rate path is extracted from the estimated term premia, suggesting that policy rates are expected to remain broadly stable in the near term and decline gradually thereafter. Analysis of the interaction between monetary policy and the bond market shows that policy rate shocks significantly raise expected policy rates, while shocks to expected policy rates also lead to increases in the actual policy rate. This implies a high degree of mutual credibility between the central bank and the government bond market.

Using this decomposition, the study examines the effects of domestic and U.S. monetary policy shocks on KTB yields. Domestic monetary policy shocks generate significant spillovers across the entire yield curve, from short- to long-term maturities. Short-term yields respond mainly through changes in the expected policy rate path, whereas long-term yields respond more strongly through adjustments in term premia. In contrast, U.S. federal funds rate shocks do not exert statistically significant effects on KTB yields. However, U.S. forward guidance and quantitative easing shocks exert meaningful impacts. Quantitative easing shocks produce larger short-term effects, while forward guidance shocks exhibit greater persistence. Nevertheless, these spillovers are considerably shorter-lived than those from domestic monetary policy shocks, highlighting the relative independence of Korea’s monetary policy.

The study also analyzes the Korean corporate bond market in the context of domestic and external monetary policy. Although the corporate bond market has expanded steadily in terms of outstanding issuance, secondary market liquidity remains limited, with turnover ratios substantially lower than those in the government bond market and trading concentrated in financial bonds. U.S. monetary tightening is found to reduce corporate bond trading volumes and widen credit spreads, with a 25 bp increase in the U.S. policy rate leading to an immediate spread widening of 11―13 bp. Over a horizon of one to three months, corporate bond spreads increase by 28―56 bp. Domestic monetary policy shocks also have significant effects on corporate bond yields, with particularly pronounced responses in lower-rated (BBB-) bonds. By contrast, firm-level financial conditions do not appear to systematically influence the sensitivity of corporate bond yields to U.S. monetary policy shocks, likely reflecting a flight-to-quality behavior during tightening episodes.

Summary

KDI FOCUS Korea’s Trade Structure since 2010 and Implications for Economic Security

Recent shifts in Korea’s trade structure are characterized by a broad-based rise in imports from China and a concentrated expansion of exports to the United States in a small set of products, resulting in deeper bilateral trade dependence with both economies. These structural shifts introduce multiple risks, including supply chain vulnerability, job losses in sectors competing with Chinese imports, exposure to U.S. protectionism, and macroeconomic instability. Proactive trade diversification through coordinated policies and targeted export promotion initiatives is essential, alongside institutional reforms to shield affected industries and workers. This agenda should remain a policy priority even after the current trade negotiations with the U.S. are concluded.

- Responses to U.S. tariffs dominate attention while Korea’s shifting trading structure remains overlooked.

- Korea’s recent trade features a shift to a deficit with China, a growing surplus with the U.S., and rising dependence on both.

- Korea’s trade balance deterioration with China stems from net import growth in broad manufactured products, while its U.S. trade surplus expansion is driven by exports of a few products, including automobiles and semiconductors.

- Korea’s import and export shifts have elevated its country-level import concentration and product-level export concentration above other major economies.

- Technological, industrial, and policy shifts of the U.S. and China, alongside their escalating geopolitical tensions, continue to shape Korea’s trade patterns.

- Rising supply chain dependence on China poses the risk of negative spillover effects not only on Korea’s current key industries but also on future strategic ones.

- Intensified competition from Chinese imports raises concerns about employment declines and deteriorating job quality in Korea’s manufacturing sectors.

- Korea’s export growth to the U.S., concentrated in a few products, increases the likelihood of becoming the target of U.S. tariff measures.

- Deepening trade dependence on a few countries and products may increase macroeconomic instability.

- Export and import diversification calls for stronger national economic diplomacy and trade cooperation, alongside accelerated CPTPP accession.

- Expanded support is needed for export and import firms to diversify trading partners and product portfolios, prioritizing policies with proven effectiveness.

- Protecting domestic industries calls for stronger monitoring and response systems for unfair trade practices, alongside assistance that helps affected firms and workers adapt swiftly to the changes.

Summary

Policy Study KOR Impact of Global Trade Fragmentation on South Korea’s Exports: The U.S-China Trade War and Policy Insights

This study analyzes the effects of the U.S.-China trade war on third-country exports to the U.S. and China, focusing on South Korea. Using tariff change data that occurred during the 2018~19 US-China trade war, it estimates product-level elasticities of substitution, i.e., tariff cross-elasticities, and investigates their determinants across countries, industries, and products. This analysis elucidates the heterogeneous effects of the trade war, informing policies to seize new export opportunities amid ongoing global trade fragmentation.

The results show that Korea’s tariff cross-elasticities toward the U.S., relative to U.S. tariffs on Chinese imports, were generally positive, implying that higher U.S. tariffs tend to boost Korean exports to the U.S. In contrast, the elasticity toward China, relative to Chinese tariffs on U.S. imports, was negative on average, suggesting that increased Chinese tariffs tend to reduce Korea’s exports to China. Comparing predicted and actual export changes reveals a potential underestimation bias in the regression model.

Decomposing the determinants of tariff cross-elasticities into country, industry, and product factors reveals the significance of country-specific elements for exports to the U.S. and China, with industry factors also exhibiting relevance for exports to the U.S. In the case of Korea, tariff elasticities were higher in high-tech, capital-intensive, or export-integrated industries.

Additionally, analysis of Korean manufacturing shows that industries with economies of scale reduced production costs and expanded output during the trade war. Zooming into factors for economies of scale, capital-intensive industries with prior investments saw increased value-added, expanded investment, and lower costs. Export-integrated industries exhibited similar positive outcomes.

Lastly, simulations based on the estimated elasticities project that four U.S.-China tariff scenarios increase Korea’s exports to the U.S. by 0.1% to 7.0%, depending on the extent of U.S. tariff changes on Chinese imports. In a severe scenario where both countries impose roughly 10%p additional tariffs on all bilateral imports, Korea's exports are projected to rise by about 4.7% to the U.S. and 9.1% to China.

These findings inform policy decisions for Korea to navigate global trade changes, such as the U.S.-China trade war, by prioritizing targeted support for high-tech and capital-intensive industries and bolstering investment and export infrastructure to enhance resilience and capture emerging export opportunities.

Summary

Policy Study KOR Strengthening Macroprudential Management for Non-Bank Financial Institutions in Korea: Focusing on the Issuance of Equity-Linked Securities (ELS)

This study proposes measures to strengthen macroprudential management for non-bank financial institutions (NBFIs), such as securities firms and insurers, whose importance has grown since the 2008~2009 Global Financial Crisis. Major economies and international financial institutions have actively discussed and pursued new or enhanced supervisory and regulatory frameworks for managing NBFI-related systemic risk.

Using ΔCoVaR, a leading systemic risk metric capturing changes in conditional value at risk, this study analyzes the evolution of systemic risk among South Korea’s banks, securities firms, insurers, and individual financial institutions during major financial shocks, including the Global Financial Crisis, the European Debt Crisis, and the COVID-19 pandemic. Findings reveal substantial increases in systemic risk across all sectors during each crisis, with banking generally exhibiting the highest levels. Sectoral differences varied, with risk for securities firms surging during the March 2020 margin call event, markedly narrowing the gap with banks compared to previous crises.

The study further empirically examines the impact of Equity-Linked Securities (ELS) issuance by financial institutions on systemic risk (ΔCoVaR). Results indicate that increased ELS issuance contributed significantly to heightened systemic risk during the Global Financial Crisis, the European Debt Crisis, and the COVID-19 crisis. These findings underscore the growing importance of NBFIs in macroprudential management and call for systematic monitoring with enhanced regulatory oversight of the non-bank financial sector.

Summary

Policy Study KOR Investor Composition of Government Debt and its Fiscal Implications

This paper estimates the demand for South Korea’s government bonds across investor categories and projects future bond yields in light of the country’s rising debt trajectory. A cross-country analysis shows that public and non-bank sectors have been key drivers of increased foreign investor holdings of Korean government debt during the COVID-19 pandemic. Using sectoral debt holdings data, the paper examines the evolution of marginal holdings of government bonds by each sector and estimates the responsiveness of debt demand to bond yield changes. Over the past decade, domestic banks and public institutions, including the National Pension Service, have reduced their marginal holdings, while private pension and investment fund sectors have increased theirs. These findings highlight the growing importance of non-bank sectors in government debt demand, consistent with the literature (Fang et al., 2022). Foreign investors exhibit the highest demand sensitivity to bond yields, whereas domestic insurance companies show the lowest. Based on sectoral demand estimates, a 10% increase in government debt is estimated to raise bond yields by 43 basis points. By 2030, when Korea’s government debt is expected to reach 2,000 trillion won, bond yields are projected to rise to 4.85%, ceteris paribus. Notably, 60% of the projected yield increase is attributed to the inelastic demand of insurance companies. This underscores the importance of adjusting the investor composition of the government bond market, with a greater share of investors with higher demand elasticity to alleviate pressure on borrowing cost.

Summary

Policy Study KOR Capital Flows and Challenges in the Digital Age: Focusing on Central Bank Digital Currencies (CBDCs)

As the digitalization of finance accelerates, discussions on the adoption of Central Bank Digital Currencies (CBDCs) are gaining momentum, particularly among G20 nations. This development calls for examining the potential impacts of CBDC implementation on both domestic and international financial markets and capital flow, alongside exploring appropriate response strategies. Upon reviewing the status and background of CBDC adoption among G20 countries, setting up a unified CBDC platform for this group in the short term is highly unfeasible. Instead, some emerging economies are expected to introduce retail CBDCs to enhance payment infrastructure or conduct experiments linking wholesale CBDCs for cross-border payments. Should CBDCs be adopted globally, the speed and scale of international capital movements could increase, potentially amplifying the volatility of capital flows and currency values. In order to ensure the effectiveness of capital flow management policies already in place, it is crucial to foster close cooperation between major central banks on CBDC integration. Moreover, efforts should be made to maximize the benefits of the new payment systems introduced by CBDCs. These efforts include revising financial regulations and upgrading infrastructure by implementing open foreign exchange regulations, maintaining balanced oversight of fintech firms, and enhancing the efficiency of existing payment and settlement infrastructures.

Summary

Research Monograph KOR Foreign Direct Investment in Korea: Performance Evaluation and Policy Implications

Countries are actively seeking ways to attract foreign direct investment (FDI) as a crucial instrument for economic growth, and Korea is no exception. The Korean government has been an ardent supporter of FDI after switching its stance on FDI as a key source of materializing its growth potential after the 1997 Asian Financial Crisis. Currently, Korea implements a wide range of support measures, such as location choice assistance by establishing Free Trades Zones, Foreign Investment Zones, and Free Economic Zones, tax reductions and exemptions, and cash grants. However, despite its extensive efforts, the inflow of FDI remains small, while the outflow of FDI by domestic firms continues to rise.

Underlying this stance is a hypothesis that the gain outweighs the cost, which means the positive ripple effects of FDI on the overall Korean economy are greater than the monetary value of incentives given to foreign investors. Still, that hypothesis needs to be verified. As for the productivity spillover effects of FDI in Korea, the prior empirical studies show mixed results, both positive and negative or ineffective. Also, previous studies empirically comparing foreign-invested enterprises’ performance with domestic firms had contradictory results.

Such conflicting conclusions are primarily due to statistical restraints. The scope of data on foreign-invested firms studied previously is narrow because information disclosed by the government is extremely limited. In order to overcome this shortfall, this study employs a complete enumeration of data on foreign-invested enterprises operating in Korea, provided by the Ministry of Trade, Industry and Energy, to analyze their business performance as follows. First, an analysis method of propensity score matching is used to see if there is a significant difference in operational performance between foreign-invested and domestic companies in the manufacturing and services industries at the enterprise level. Second, it also estimates the effect of FDI on the productivity of domestic firms in the manufacturing industry. Accordingly, this study calculates their firm-level productivity to estimate the effect of productivity spillovers from FDI, taking into account foreign-invested companies’ impacts on their local competitors as well as on upstream and downstream domestic companies.

This study analyzes firms operational on the 2019 KIS-DATA using a control group of domestic firms similar to foreign-invested firms in terms of firm age, size, wage level, and debt ratio. The results are summarized as follows. First, as to two productivity indicators, labor productivity and per capita operating profit, it finds no empirical evidence to support the hypothesis that foreign-invested companies perform better than domestic ones in manufacturing and service industries. Rather, domestic firms outperformed their foreign competitors in the service industry. Second, in terms of growth potential measured by the average annual growth rates of per capita value-added and sales over the past five years (2015-2019), there is no empirical evidence to support the hypothesis of better growth potential among foreign-invested companies. Third, as to innovation capacity measured by the proportion of R&D expenditures and costs of education and training to sales, no empirical evidence is found to support the hypothesis of a higher level of innovation for foreign-invested firms in the manufacturing industry than their domestic counterparts. However, the analysis finds that R&D intensity in the service industry was much more significant for foreign-invested companies.

This study also examines business establishments operational on Statistics Korea’s 2003-2009 Mining and Manufacturing Survey to see the effect of FDI enterprises on the productivity of domestic manufacturing firms. First, it finds the productivity of foreign-invested companies in the mining and manufacturing industries to be 8% higher than that of local competitors after controlling for other effects. Second, the analysis using level statistics finds the impact of FDI on the production of domestic firms to be negative in all cases of the competition effect on the same industry, forward linkage effect on the productivity of the downstream sectors as foreign-invested companies supply intermediate goods to them, and backward linkage effect on the productivity of the upstream industries as foreign-invested companies consume the output from them. However, large-sized foreign-invested enterprises positively impacted the productivity of other firms in the same industry. Third, the result shows that the growth of highly productive foreign-invested companies positively influenced the productivity of upstream firms. Such a positive effect appears to grow over time and become stronger for the larger foreign-invested firms. While no positive effect was observed for the same industry and downstream industries with time, FDI had a significantly more positive impact on the productivity growth rate of industries with a high share of the production of intermediate goods.

In conclusion, the finding that FDI negatively impacts the productivity of domestic firms raises a serious question as to whether Korea’s foreign investment support policy has effectively achieved its intended goals. A key implication from the results of this study is that future FDI policies should focus more on quality over quantity. To this end, the Korean government needs to develop a comprehensive index model that can measure not just the total amount of FDI but also the positive effect of foreign-invested companies on the Korean economy in various aspects like productivity and employment. Moreover, this index should be utilized to evaluate and further advance FDI support policies. Currently, the criteria for government assistance to attract foreign investment are confined to the amount of investment and the size of employment, but more diverse indicators need to be incorporated, taking into account growth potential. Furthermore, the government should shift its focus to attracting quality multinationals as well as creating a business environment conducive to their growth and sustainable development in the host country.

Summary

Research Monograph KOR Economic Security and Strategies to Strengthen Supply Chains

On top of the US-China strategic competition, the COVID-19 pandemic, climate crisis, and rising geopolitical risks have pushed economic security and supply chain policies to the forefront of policy dialogue in South Korea. This study examines the factors behind the growing importance of economic security and response measures from geo-economic and traditional economics perspectives, along with analyses of case studies in key sectors. The primary aim of this research is to identify strategies to enhance Korea's economic security.

The policy directions regarding Korea’s economic security presented in this study are as follows: First, Korea should build upon its manufacturing capabilities in advanced industries and actively foster related cutting-edge technologies to secure strategic advantages. To achieve this, industrial policies should be more closely integrated, and supply chain vulnerabilities should be mitigated particularly by reducing dependence on China.

Second, simple localization or domestication of intermediate goods suppliers should be avoided. Instead, the Korean government should actively participate in international joint investment and R&D cooperation to support private-sector investments for diversifying supply chains.

Third, the strategy of large enterprises sharing technological know-how with small and medium-sized enterprises (SMEs) with similar technological development goals has been a key driver of Korea’s high localization rate and international competitiveness in the display industry. Therefore, in promoting the localization of advanced strategic sectors, the government should enhance support for improving the technological capabilities of domestic supply chain firms. Moreover, industry associations should establish various mechanisms and channels to strengthen collaboration between advanced industries firms and supply chain firms.

Fourth, a stable supply of mineral resources urgently requires investment in R&D, international cooperation, and the mobilization of financial resources for large-scale investments. Expanding R&D in mineral resource development technologies and leveraging these efforts as a platform for international cooperation should be prioritized. Additionally, concrete strategies for securing financial resources to support large-scale investments should be explored.

Fifth, when supply chain crises in advanced strategic industries pose risks that can potentially escalate to national crisis level, it is critical to consider adopting the 'emergency acquisition flexibilities' strategy used in defense material procurement. To this end, existing systems should be restructured to enable rapid procurement and response, ensuring greater resilience in times of crisis.

Sixth, to enhance the competitiveness of advanced strategic industries, priority should be placed on expanding power generation capacity through targeted investments in energy infrastructure. Simultaneously, measures such as connecting and expanding power grids, developing smart grids, and diversifying energy resources to improve efficiency should be pursued. As for water resource infrastructure, ensuring quantitative stability requires the multipurpose use of existing infrastructure, the activation of alternative water resources, and the construction of new water resource infrastructure. Additionally, strengthening technological capabilities through localization efforts is essential to securing a stable supply of ultrapure water.

Last but not least, prompt establishment and implementation of a national logistics strategy is required to adapt to changes in the global logistics network. This strategy should focus on securing overseas networks and global logistics hubs, as well as fostering globally competitive logistics companies, and enhancing adaptability to shifts in the logistics environment.

Summary

Policy Study KOR Impact of Carbon-Neutrality Policies:Focusing on Trade and Environment

This study examines the impact of carbon neutrality policies on Korea and explores potential government responses to the rapidly evolving global policy landscape concerning carbon and trade. Specifically, it focuses on the European Union’s Carbon Border Adjustment Mechanism (CBAM) and how South Korea's carbon neutrality policies might influence the CBAM's impact. In addition, it analyzes the effects of each carbon neutrality policy option on Korea’s economy, including trade and GDP, and emissions.

This study finds that the EU CBAM may not affect Korean exports due to its relatively narrow scope of products and emissions covered in the current version of the policy. However, its influence is likely to grow if the scope of regulated products expands and the range of indirect emissions covered increases. The study then considers carbon pricing, green technology R&D, and green supply chain policies as strategic directions for Korea's government to both respond to global policy changes, such as CBAM, and achieve climate neutrality. Although both increasing carbon prices and developing carbon reduction technologies mitigate the negative impacts of CBAM by decreasing CBAM tariff rates, their effects on Korea's production, exports, income, and welfare differ.

Green supply chain policies involve adjusting trade costs according to the carbon intensity and price of intermediate inputs’ origins. This aims to reduce production's embedded indirect emissions and increase the carbon price already paid in source countries. The study evaluates two opposing approaches to implementing this policy: lowering trade costs for 'green' suppliers and raising them for 'dirty' suppliers. The results indicate that decreasing trade costs, as opposed to increasing them, results in higher GDP, greater export competitiveness, and improved welfare. The study shows that although different policy options are themselves effective in responding to CBAM and reducing carbon emissions in Korea overall, their impact on Korea’s economy and emissions are heterogeneous. Therefore, understanding the complex consequences of these policies and selectively implementing them based on the distinct characteristics of the affected industries is crucial.

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