KOREA CAPITAL MARKET INSTITUTE

Korea’s Foreign Exchange Transactions Act (hereinafter referred to as the “Act”) that prescribes all matters concerning foreign transactions and FX dealings has been enforced after being enacted following the Asian financial crisis. The Korean government (the Ministry of Economy and Finance) has continued to revise and improve the Act while keeping its fundamental framework intact. But last year it embarked on a full-scale reform of the Act, considering changing macroeconomic conditions in Korea and abroad. Under the context, this article intends to analyze previous revisions and characteristics of the Act and explore the need for amendment amid changes in internal and external macroeconomic conditions, and to outline the desired direction for the legal framework reform and major challenges.

   
1. Changes and characteristics of the Foreign Exchange Transactions Act

Korea’s FX transaction-related law has originated from the Foreign Exchange Control Law that was enacted in December 1961 with reference to Japan’s legal system for FX transactions. Back then, Korea in the initial stage of economic development suffered from a lack of foreign currencies in absolute terms, thereby strictly controlling import and use of foreign currencies through the Foreign Exchange Control Law.
 
Immediately after the Asian financial crisis was over in April 1999, the Foreign Exchange Control Law was replaced by the current Act that aimed to shift from the management-based framework to a more voluntary system, with the introduction of follow-up management principles focusing on the ex post facto reporting and soundness monitoring of FX transactions. Since then, Korea has partially adopted liberalization measures including liberalization of foreign currency trading by individuals, abolition of the capital transactions permit system, and introduction of the negative regulation. Also, the new FX transaction-related law was planned to take effect from 2009, but in the aftermath of the 2008 global financial crisis, only partial revisions to the existing Act have been made until the present.
 
The purpose of this Act defined in Article 1 is to “contribute to the sound development of the national economy by striving to facilitate foreign transactions to maintain equilibrium in the balance of payments and to stabilize the currency value by ensuring liberalization of FX transactions and of other foreign transactions, and by invigorating market function”. On one hand, the Act intends to ensure more autonomous transactions and facilitate market functions. On the other hand, it aims to maintain external equilibrium and stabilize the macroeconomy. However, the Act has been practically applied with the focus on the latter. In Korea, there has been the deep-rooted philosophy of “curbing outflow and promoting inflow of foreign capital”, dating back to the era when the nation faced a foreign exchange shortage. Furthermore, in the wake of the 1997 Asian financial crisis and the 2008 global financial crisis, Korea has been well aware that the stability of the FX sector is of paramount importance in the national economy. Such philosophy and awareness have underpinned the legal framework and enforcement system of the Act.
 
As a result, the existing Act seems to fail to properly reflect rapid changes in internal and external macroeconomic conditions. For example, out of Korea’s foreign transactions, most capital transactions excluding current transactions are still subject to the prior reporting system (or acceptance of a report) although the permit system was abrogated. Under the current capital transactions reporting system, the matter to be reported and the agency in charge of reporting process vary depending on the transaction volume, the counterparty, or the possibility of foreign capital outflow. This means that unlike the ex post facto reporting designed for monitoring, the current system serves as an obstacle to convenience and autonomy in capital transactions by causing economic agents inconvenience and incurring administrative costs.
 
In addition, Korea operates foreign exchange agencies, most of which are banks (FX banks) playing a key role in the FX business. In other words, the FX business is generally recognized as the work exclusively undertaken by banks and foreign currencies can be remitted only via banks, excluding remittance of small sums. This situation has solidified the FX bank-centric concept that encourages banks to serve as an impediment to capital outflows. These days, various financial instruments emerge in the capital market and non-banking financial institutions increase their presence on the back of greater capital flows resulting from domestic and overseas stock investment. The FX bank-centric system goes against such changes in the market and also has an adverse influence on external soundness.
 
Notably, the two financial crises of the past have made Korea focus its policy capability on alleviating exchange rate volatility and stabilizing the FX sector. Hence, the Korean economy has made conservative policy responses in terms of deregulation for the FX system advancement and internationalization of the Korean won currency. It is an undeniable fact that despite the steady growth of the stock market and capital market, Korea has yet to be treated as an advanced economy on the global stage due to absence of the 24-hour FX market and various FX regulations.

       
2. Changes in internal and external macroeconomic conditions and need for the reform of the Foreign Exchange Transactions Act

The following is a brief look at changing macroeconomic conditions taking place in Korea and abroad, which have reinforced the need for an overhaul of the Act.
 
2.1 Transition from a nation facing a foreign exchange shortage to a capital exporter

As mentioned above, the Act is still constrained by the previous policy stance of curbing outflow and facilitating inflow of foreign capital in that the prior reporting system for capital transactions or the FX bank-centric concept remains effective in the Act. This implies that the Act has failed to fully take into account Korea’s recent favorable macroeconomic conditions and structural improvements in external soundness. As a huge current account surplus has continued to accrue for about 20 years, the Korean economy’s reliance on foreign debt has significantly declined and measures for enhancing macroeconomic prudence have helped alleviate the risk from sudden foreign capital movements. A great deal of current account surpluses have boosted the value of overseas savings, thereby making Korea become a net creditor nation. Simply put, it has moved away from an economy with a foreign exchange shortage long ago and now enjoys the position of a capital exporter. Based upon abundant FX reserves and good national credit ratings, the nation has already reached the level of developed economies in terms of the crisis management capability of FX authorities. This necessitates a clear shift from the existing framework and management of the Act that was designed to stabilize FX demand and supply and attain external equilibrium.
 
2.2 Growing presence of international capital flows and non-banking financial institutions

In Korea’s foreign transactions, a switch from current transactions including imports and exports has taken place and capital transactions have gained importance. This phenomenon is the result of globalization and liberalization that have evolved since the 1990s, which can be observed not only in Korea but also around the world. Since 1992 when Korea opened its capital marke, foreigners have considerably increased their investment in stocks and bonds, reaching nearly KRW 1 trillion in value as of the end of 2021. As abundant FX reserves from the accumulation of current account surpluses are increasingly put to overseas savings, retail investors, as well as institutional investors such as the National Pension Service, have recently joined the outbound stock investment boom. In the traditional system, a nation’s foreign transactions are primarily composed of current transactions including international trade conducted by importers and exporters and banks support FX transactions of companies. This system helps achieve the balance of payments and maintain external stability without difficulty through the management of FX supply and demand.
 
However, international capital transactions have recently expanded in the form and volume and a wide range of financial instruments have been introduced to the capital market, which triggers greater volatility in capital flows. Under the situation, it is ineffective to structure the FX legal framework centered on FX banks. The increase in international capital mobility brings about abrupt inflow and outflow of capital, thereby threatening the overall financial stability. A case in point is the foreign currency liquidity crisis affecting Korea’s securities firms two years ago. The immediate factor behind the crisis may be greater FX exposure resulting from the growth of ELS sales and a margin call arising out of a sharp drop in global stock prices. But a more fundamental cause can be found in the bank-centered FX business practice that discourages non-banking financial institutions to improve capabilities in FX business process and FX risk management.
     
2.3 Decline in potential growth amid the aging population and low interest rates

The structural problems faced by the Korean economy can be pointed out as population aging, the entrenched low interest rate stance, and the decline in potential growth. To fix these problems, it is necessary to increase returns on investment through overseas savings and boost the economic growth rate based on the increase in disposable income, which should be well reflected in the reform of the Act. 
  
What is noteworthy is the Japanese Big Bang financial reform that was implemented in 1998 when the revised Foreign Exchange Control Law was introduced because economic conditions Japan experienced back then were similar to the current situation faced by Korea. Japan pushed ahead with the Big Bang to give an economic boost to the aging society while trying to increase disposable income by broadening outbound investment and raising the primary income with the complete liberalization of FX transactions. With the financial system reform, Japan attempted to derive more profits from interest and dividends on overseas financial assets to improve the return on investment and facilitate economic growth in the aging society. To this end, it eliminated a prior reporting system or reporting regulations that were applied to capital transactions or FX transactions executed by individuals or firms, leaving intact the ex post facto reporting system for monitoring purposes. Furthermore, the financial reform abolished the authorized FX bank system, permitted opening an account with overseas banks, and lifted the FX position regulation imposed on financial institutions’ FX holdings. In this reform, Japan’s revised Foreign Exchange Control Law played a pivotal role in stimulating growth through expansion of overseas savings, which could have significant implications for Korea.
 

3. Reform direction and relevant challenges

Since its enactment, the Act has contributed immensely to achieving external equilibrium and sustaining external stability. In line with changing macroeconomic conditions in Korea and abroad, however, Korea should seek to implement a forward-looking reform of the Act on the following two fronts.
    
First, the Act needs to be overhauled to improve convenience and autonomy in FX transactions, which requires simplifying a prior reporting system for capital transactions and rationalizing existing regulations. But given the nature of capital transactions, a large amount of capital could be drained all at once and it is difficult to authenticate transactions. Therefore, a minimum monitoring system should be kept in place to deal with issues such as external soundness control, tax evasion, and illegal capital movement. In addition, as for nonconventional transactions via institutions other than banks, reasonable adjustment needs to be implemented, for example, by narrowing down the range of transactions to be reported.
 
Second, the foreign exchange agency system should be reassessed to supplement defects of the FX bank-centered system. Despite greater FX exposures backed by qualitative and quantitative growth of the capital market and the emergence of new financial products, Korea’s non-banking financial institutions including securities firms are still affected by FX business-related constraints and need to further strengthen their FX business capabilities, compared to banks. In the case where the Financial Investment Services and Capital Markets Act permits non-banking financial institutions to engage in FX transactions and in particular, any direct FX outflow has never occurred, it is necessary to ensure autonomy in relevant FX transactions to reinforce non-banking institutions’ FX business capability and prevent the institutions from undermining external soundness.
    
Third, it is desirable to guide the Act to contribute to the development of new growth engines. Amid the increase in overseas financial assets, relevant regulations that remain effective under the Act should be reformed to ensure that overseas investment would lead to a higher return on investment and growth of national disposable income in the era of the aging population. Also important is the improvement of convenience for foreigners investing in Korea to secure a stable stream of capital and alleviate volatility in the financial market. Currently, the Korean government strives to ensure that Korea's stocks would be included in the MSCI World Index. The nation needs to take this as an opportunity to rebuild the substructure of its FX sector and relax FX regulations. It is also necessary to pursue internationalization of the Korean won currency with the establishment of the 24-hour FX market, which would help overcome limitations inherent in the FX sector and achieve external soundness.
        
Lastly, efforts should be put into maintaining soundness in the external sector. To sustain external soundness, it is important to guarantee convenience and autonomy in FX transactions while setting up the regular monitoring and ex post factor reporting systems. In this respect, the FX sector’s macroprudential measures that have played a critical role in stabilizing the external sector should be aligned with the Foreign Exchange Transactions Act to be revised. Additionally, safeguard policies for market stability need to be scrutinized in preparation for the urgent situation where external shocks bring about greater volatility to the financial market. Hopefully, the newly revised Act would take into consideration internal and external changes to reinforce economic players’ capability in the international financial sector and to revitalize the national economy.