How South Korea’s National Pension Service Can Help Manage Financial Crisis

By Yaechan Lee

Financial globalization under the dollar-based structure of the international monetary system is increasingly demanding more proactive policy actions from central banks to prepare against potential capital outflow as investors make the dash for the dollar during financial crises. During the COVID-19 crisis, research finds that even the central banks of developing economies have expanded their balance sheets, proactively intervening in capital markets to offset the negative effects of excessive capital flight.

In my new journal article with William Grimes in the Review of International Political Economy, we find that interventions to offset the negative repercussions arising from market dislocations in times of crises can be carried out not only by central banks but also by public financial institutions.

In the article, we focus on how South Korea has used the National Pension Service (NPS) as the first line of defense against such market dislocations. South Korea has had a strong legacy of state-driven growth, where the state held strong control over key financial institutions to allocate capital to preferred industries and control capital flows. One such institution (and the most substantial one) was the NPS. A pension system for a wider population of private sector employees was first introduced in 1988, but initially, the accumulated fund from contributions was centrally managed by the state through the NPS. The fund was then used for industrial policy purposes, with its investments heavily focused on public infrastructural projects.

The NPS investment practices changed after the Asian Financial Crisis following policy recommendations from the International Monetary Fund, which saw the NPS’s investments as unsustainable in the long run given that returns from public projects had low returns. The NPS became more profit oriented as a result, was promised a higher level of autonomy in making investment decisions and seemingly operated under liberal market norms afterward.

We find, however, that the state has maintained strong control over the governance structure of the NPS and its decision-making processes even after its reforms. The legacy of the state’s control over the NPS remains hidden in non-crisis times but surfaces during crisis times when the state needs the NPS to respond to imminent challenges instigated by financial crises.

In other words, during crises, the NPS operates based on the state objectives of financial stabilization rather than operating as a profit-maximizing financial institution. The state has used the institution’s funds to stop excessive capital flight by implementing bond purchase programs through the NPS and limiting excessive involvement from its central bank, thereby using the NPS as the first line of defense against market dislocations.

The NPS’s activities in the 3-Year (3Y) sovereign bond markets in South Korea suggest strong evidence for this argument. This additional policy option allowed South Korea’s central bank to maintain a modest level of direct purchases in the capital market for financial stability. This is important, as such interventions from the central bank should wind down when financial stresses ease to eliminate future inflationary pressures on the economy. On the other hand, the NPS’s interventions involve temporary shifts in its investment portfolio, which can be quickly reversed when financial stresses ease, as we find in the NPS’s activities in the 3Y sovereign bond market during the Global Financial Crisis and the COVID-19 crisis.

This key finding carries important implications on how past legacies of state-driven economic growth in East Asian economies continue to have an impact on their policy practices, and on the potential importance (and usefulness) of public financial institutions in emerging market economies in countering excessive capital flight. It also indicates that in addition to central bank readiness against crises, the capital mobilization capacity of public financial institutions and the state’s ability to govern the direction of capital mobilization should also be taken into consideration when assessing the financial resilience of economies.

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