korean trade and financial linkages with the u.s. and japan

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Korean Trade and FinancialLinkages with U.S. and Japan

Maziar Kazemi

May 2011

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I. Introduction

At the turn of the 21

st

century, the world economy was more globalized

and integrated than ever. The forces behind this increased globalization

have been the subject of much research, and as technological and

financial innovations continue to increase, one would expect this process

of economic integration to continue. In examining the increased

integration of national economies, the relationship between advanced

economies (AEs) and emerging economies (EMEs) is of particular interest.

Globalization and economic integration have had particularly pronounced

effects on the economic performance of EMEs. Many EMEs look to

international trade and capital flows as positive forces to help them

promote economic growth, increasing the standard living of their citizens.

Trade openness among EMEs has nearly doubled since the 1980s, and

financial openness- measured as gross assets and liabilities as percent of

GDP- has nearly tripled in the same time period.1

The purpose of this paper is to first present a simple measure of

integration between an EME and major AEs. Next, having shown that the

EME is well integrated into the global economy, the paper will employ

1 Felices, et al. 2008

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multivariate regression to examine the factors that affect trade and

capital flows between the EME and its major trading partners.

My focus will be on the Republic of Korea (henceforth Korea) and its two

major trading partners from the developed world, namely the U.S. and

Japan. Korea represents an EME and the U.S. and Japan are two major

AEs. The U.S. is naturally of interest for this study, as it is the largest

economy in the world as well as a major trading partner of Korea. Japan

is also important not only because it is the third largest economy in the

world but has significant influence on East Asian economies.2

Korea is a member of the Asian newly industrialized countries (NIEs)

along with Hong Kong, Singapore, and Taiwan. Coupling this classification

with its stable political situation, and increasing economic integration with

the global economy, makes Korea a good example of an EME for this

study. Because it has a stable political system, we do not need to be

concerned about political instability causing major fluctuations in trade or

capital inflows.3 Japan, because of its geographical proximity, and the

US, because of its historical ties to Korea, are major influences on the

Korean economy. The relationship between the U.S. and Korea was

2 McKinnon, 20043 Of course one cannot ignore the influence of North Korea and its saber rattling policies onKoreas economy. However, it appears that with very few exceptions, Korean financialmarkets have come to ignore hostile pronouncements that come out North Korea.

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recently extended further by the signing of the free-trade agreement

between the two countries in June of 2007. Consequently, our choice of

the U.S. as an AE to be examined is particularly interesting. Finally, as

will be shown later in the paper, the empirical evidence supports the

notion that financial linkages between Korea and the U.S. and Japan are

particularly strong.

The first goal of the paper is to empirically examine the strength of

financial linkages between Korea and the U.S. and Korea and Japan. For

this purpose, I estimate the correlation coefficients between each pair of

countrys Financial Stress Index (FSI). This index was developed by

Balakrishnan, Danniger, Elekdag, and Tytell (2009) and will be further

described later.

Next, I shall further explore these financial linkages by examining the

factors that affect trade and capital flows between Korea and the US and

Japan. I employ two multivariate regressions to study the impact of

these factors. Regression 1 (REG1) examines the determinants of Korean

net exports, defined as a flow of goods and services. Specifically, I will

look at the effects of changes in the relevant exchange rates as well as

the impact of changes in the GDP of the U.S., Japan, and Korea.

Regression 2 (REG2) examines the determinants of net portfolio

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shows, Korean GDP5 has steadily increased since 1999, with the notable

dip during the recent financial crisis.

Figure 1--Korea's GDP

0.000

50000.000

100000.000

150000.000

200000.000

250000.000

300000.000

Jul-98 Apr-01 Jan-04 Oct-06 Jul-09 Apr-12

on,ons

Date

GDP

Source: IMF Statistics

As an NIE, Korea has a fairly advanced and thriving private sector. It has

10 companies listed in the Fortune 500, with Samsung listed as number

32. Besides having a rather strong domestic economy, Korea has

significantly increased its integration with the rest of the world. The

countrys openness- measured as the sum of exports and imports as a

percentage of GDP- has increased from 65% in 1999 to a peak of 118%

by the end of 2008. Figure 2 shows this trend over the past decade, and

as in the GDP graph, we see another notable dip during the recent

financial crisis.

5 Note: GDP has been seasonally adjusted.

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Figure 2--Korea's Trade Openness

0

0.2

0.4

0.6

0.8

1

1.2

1.4


%oGDP

Date

Openness

Source: IMF Financial Statistics

Similarly, we might measure the change in Koreas financial openness, which

is measured as the sum of foreign assets and foreign liabilities as a

percentage of GDP. Once again, as Figure 3 shows, this measure of

openness has increased as well. In the first quarter of 1999, Koreas

financial openness was around 75% of GDP. Since then, it has reached a

level of well over 100% of GDP.

Figure 3--Financial Openness

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0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6


%ofGDP

Date

Financial Openness

Source: IMF Financial statistics

III. Role of the Yen and the Dollar

Japan and the U.S. are not the countries of choice in our comparison with

Korea simply because they are two large AEs. There is significant

literature on the importance of the US dollar and the Japanese yen in East

Asian emerging economies, including Korea. One manifestation of this

importance is the so-called Original Sin. According to Eichengreen

(1999), Original Sin occurs when a country cannot borrow freely in its

own currency. This difficulty is present not only in EMEs but in some AEs

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as well. A country whose currency serves as a global medium of exchange

and store of value does not face this problem. For instance, because of

the role of dollar in the global economy, the U.S. government and its

private sector do not face a major constraint in borrowing in terms of U.S.

dollars. This has led to a great deal of dollarization in countries that

suffer from Original Sin. In 2002, for example, 86.8% of Korean exports

and 80.6% of Korean imports were invoiced in dollars. While the yen is a

major global currency, only 5.2% of Koreas exports and 12.1% of its

imports were invoiced in yen.6

While this may indicate that for the Korean economy that the yen is not

as important as the dollar, the yen still plays a major role and is therefore

not excluded from our analysis. McKinnon (2004) shows that the

yen/dollar exchange rate has significant effects on the economies of other

East Asian nations. Notably, a depreciation of the yen/dollar rate should

drive U.S. demand for imports away from the other East Asian countries

and towards Japan.

IV. Financial Stress Index, FSI

In this section, the construction of the financial stress index (FSI) by

Balakrishnan, Danniger, Elekdag, and Tytell (2009, pg 7-9) is discussed.

6 McKinnon, 2004

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The larger the FSI value for a given country, the more strain its financial

sector is in and the less power said sector has to intervene effectively in

the global market. In addition, we will estimate correlation coefficients

between the FSI of Korea and the FSI of U.S. and the FSI of Japan to

examine the degree of financial linkages between Korea and the U.S. and

Japan. Balakrishnan et al. construct the FSI as follows:

is related to the Capital Asset Pricing Model (CAPM) and it

measures the systematic risk of the local stock market. Basically, it

is obtained by regressing the return on the local stock market

against the return on an index representing the global equity

markets. A beta of 1 indicates that the local market has the same

sensitivity to global factors as the global equity market. Therefore,

a local market with a beta greater (smaller) than one is considered

to be more (less) risky than global markets. The beta is estimated

using a 12-month moving window.

Stock market returns are calculated as monthly changes in a broad

stock market index, multiplied by negative one. This done so that

decreases in stock prices will positively affect financial stress index.

Stock market volatility is obtained from GARCH(1,1) specification,

using monthly returns.

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Sovereign debt spreads are defined as the country in questions

bond yield minus the yield on the 10-year U.S. Treasury.

The EMPI records exchange rate depreciations and declines in

foreign reserves.7

Using data provided by Balakrishnan, et al. (2009), I computed the quarterly

changes in the FSI for Korea, the U.S. and Japan from 1999 to 2009. I then

estimated the correlation coefficients for the changes in the Korean FSI

versus the changes in the U.S. FSI and Japan's FSI.8 Correlation coefficients

were estimated for the total time period of 99-09 as well as during the crisis,

07-09. Table 1 presents the results of our estimates along with the

estimated p-values.

Table 1A: Korea and Japan

Total Period Crisis Period

0.549 0.653

p-value


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Table 1B: Korea and the U.S.

Total Period Crisis Period

.567 .715

p-value


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Indexes.10 Since trade data is only available on a quarterly basis, I use

quarterly stock market data as well. The period covered by my study

begins in with the first quarter of 1999 and ends in the fourth quarter of

2009. This range covers the decade following the Asian crisis of the late

1990s and includes the financial crisis of 2007-2009.

Multivariate regressions are employed to perform the tests of this section.

The first regression (REG1) seeks to explain the determinants of net

exports for Korea, which is measured as the quarterly flow of imports and

exports. The following expression displays REG1:

For REG1, I have chosen to compare the percentage change of net

exports from one quarter to the next. Thus, the dependant variable of

REG1 measures changes in the quarterly trade flows. The independent

variables of REG1 are: (a) the quarterly percentage change in Koreas

nominal effective exchange rate (NEER), (b) the quarterly percentage

change in the won/dollar exchange rate, (c) quarterly percentage change

in the yen/dollar rate, (d) the percentage change in the yen/dollar rate

squared, and (e) lagged quarterly percentage change in the GDPs of the

10 http://www.msci.com/

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http://www.msci.com/http://www.msci.com/


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three countries. An explanation for the inclusion of some of these

variables is in order. First, Koreans NEER and won/dollar exchange rates

are natural choices. Second, as explained in Section 3, previous literature

has determined that the yen/dollar rate has significant influence on the

performance of East Asian economies. Third, the percentage change

squared is used as proxy for uncertainty in exchange rate and exchange

risk. Finally, lagged GDPs are used because changes in imports and

exports are affected by changes in domestic and foreign national

incomes.

For my second regression (REG2), I focus on net portfolio investment as

my dependent variable. The following expression shows REG2:

Notably, the data is constructed similarly to the net exports data. Net

portfolio investment is measured as a quarterly flow, in this case. The

depended variable is the quarterly percentage change in net portfolio

investment. The independent variables of REG2 are: (a) the quarterly

return on Korean stock market11, (b) the quarterly return on the U.S.

stock market12, (c) a measure of Korean stock market volatility, (d) a

11 Using MSCI Korea Index as representation of Korean equity market12 Using MSCI US Index as representation of US equity market

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measure of volatility of Koreas NEER, (e) interest rates differential using

the Korean central banks discount rate and the Federal Reserves

discount rate in a give quarter and (f) the quarterly percentage changes

in GDP variables used in REG1 (not lagged in this case). To measure the

quarterly volatility of the stock market or the NEER, I used the following

methodology,

,where returns were calculated monthly over a quarter. This is similar to

estimating standard deviation of returns if the estimated mean is zero. I

used this approach because of lack of sufficient observations in each

quarter. This approach was applied to stock market return and monthly

percentage changes in Koreas NEER. The rest of the computations follow

mutatis mutandis.

Using quarterly data, the parameters of these two regressions are

estimated. The results are discussed in the next section.

II. Results

Table 2 presents my estimates of REG1

Table 2: Results for REG1:

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We see that the won/dollar rate, lagged Japanese GDP growth, and

lagged Korean GDP growth are significant at the 10% level, at least. The

results do follow our earlier assumptions. A depreciation of the won

versus the dollar, expectedly, leads to a positive percentage change in

NX. Also, stronger Korean GDP performance tends to positively affect NX.

Normally, we would also expect imports to increase as GDP rises, causing

NX to fall. In this case, the strength of Koreans economy could be a

proxy for the strength in global economy, which should have a positive

effect on export-oriented economies such as Korea. Another explanation

for this is that the strength in the local economy provides the private

sector with the financial resources to intensify their efforts to expand in

foreign markets. Positive Japanese GDP growth causes Korean NX to fall.

This may be surprising, as we could very well expect Japan to buy more

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Korean goods, in this case, and boost Korean NX. However, the same way

that the strength in Korean economy could lead its private sector to

intensify its export policies, strength in Japanese economy may lead it to

compete more intensely in global markets and attempt to take market

share away from Korean exporters. For example, both countries are home

to major electronics companies that compete globally, and companies

from both countries tend to introduce their newest products locally before

exporting them to foreign markets.

Although the NEER, yen/dollar rate, and U.S. GDP are not statistically

significant, they have the correct signs. Similar to the won/dollar rate, a

depreciation of the NEER should have a positive influence on NX. As for

the yen/dollar rate, a depreciation of the yen versus the dollar leads to

cheaper Japanese goods abroad, and once again we see the substitution

effect, as foreigners find Japanese goods more attractive than Korean

ones. The U.S. GDP growth has a positive sign, as expected, but is the

only one of the three GDP variables included that is insignificant. This is

at first surprising. However, the U.S., being such an enormous economy,

naturally has many trade partners, and Korea usually follows in the

bottom three of the top ten total trade partners. In 2009, Korea

accounted for $67.88 billion of U.S. trade, compared to $429.64 billion

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with Canada, U.S.s top partner13. Intuitively, for every new dollar of U.S.

GDP, not a large enough portion goes to Korean trade to make this

variable significant.

The results our estimation of REG2 appear in Table 3.

Table 3: REG2

As can be seen, the estimated coefficients of three variables are

statistically significant: Korean stock returns, Korean GDP growth (not

lagged), and the volatility of the NEER. Korean stock returns, naturally,

have a positive effect on NPI growth. The reasoning is intuitive, as higher

returns in Korea attract more investors, thereby increasing NPI. Korean

GDP growth also has a positive effect on NPI. This variable was not

13 http://www.census.gov/foreign-trade/top/

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http://www.census.gov/foreign-trade/top/http://www.census.gov/foreign-trade/top/


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lagged because NPI should be more responsive to current economic

conditions. If investors sense that the Korean economy is doing well, then

we should expect net portfolio inflows to increase. Lastly, we see that our

NEER volatility index has a negative effect on NPI. Note that NEER is

traded weighted and includes other currencies besides dollar. In general,

exchange risk and uncertainty naturally has a negative effect on capital

flows as hedging this risk on regular basis would be costly. If the NEER is

highly volatile, and if it is difficult or costly to hedge exchange risk,

investors will shy away from investing in Korea.

As for the insignificant variables, the U.S. stock returns and the interest

rate differential have the expected signs. As the U.S. stock returns

increase, investors who would otherwise invest in Korea might relocate

their assets to the U.S. At first glance, we might expect a higher interest

differential to attract investors to Korea, as it might signal higher returns.

However, me must bear in mind that we are comparing discount rates,

which are set by the central bank. Investors may view a large interest

rate differential as an inflation fear, and therefore reduce their allocations

to Korean stock market. The sign on Korean stock volatility is puzzling, as

we would expect higher volatility to cause investors to shy away. One

can argue that because of the relationship between risk and return,

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investors may view current high levels of volatility as a sign of higher

future returns.

III. Conclusion

The goal of this paper was to show the influences of two large AEs on an

East Asian EME. First, we provided empirical evidence with regard to the

strength of financial linkages between Korea and the U.S. and Japan. We

were able to show that these financial linkages are strong and that they

became even stronger during the recent financial crisis. Our results

indicate that AEs have major influences on the performance of Koreans

economy.

We empirically examined the factors that affect trade and capital flows

between Korea and its trading partners. Concerning the trade flow, most

of our initial conjectures seem to have held. The strength of Koreas

exchange rates, the won/dollar and NEER, both are important to net

exports. Also, as previous literature, notably McKinnon (2004), notes,

positive changes in Japan, regarding either GDP or the exchange rate,

should have negative effects on Koreas position. Concerning our results

regarding capital flows, we confirmed that increased exchange risk tends

to reduce the flow of capital and that strong performance by the local

stock market is an important factor in attracting foreign capital.

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However, stock market volatility does not appear to be major negative

factor in this area.

The period of study covered by this paper includes the decade following

the Asian crisis of the 90s. We also captured data from the beginning of

the most recent financial crisis. As said crisis appears to be winding to its

eventual end, similar research on the periods of recession might very well

yield interesting results. Likewise, over this last decade, China has finally

surpassed Japan as the second largest economy in the world. If a paper

of this sort were to be undertaken again, it would requisite to include

China in the newer data.

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