KOREA CAPITAL MARKET INSTITUTE

In the wake of the global financial turmoil, emerging countries, including Korea, and some developed countries experienced economic difficulties from the lack of foreign currency liquidity. This was primarily due to the increasing imbalance in the foreign exchange funding market, such as the FX swap market. The imbalance still seems to exist in Korea: While downward pressure applies to the won exchange rate thanks to Korea’s huge current account surpluses and capital inflows, the FX swap market sees excess demand for foreign currency.

Against this backdrop, this study examines the current state and structural features of Korea’s FX swap market in comparison to other economies. The study conducts comparative and empirical analyses on the cause of the imbalance and stability of the FX swap market. Furthermore, I analyze how the interconnectedness between the foreign exchange market and the FX swap market has evolved since the global financial crisis.

I analyze the level of the imbalance in the FX swap market by looking at the gap between interest rate differentials and FX swap rates. According to the results, Korea exhibits higher imbalance and volatility, more severe asymmetry in distribution, and a slower pace of recovering the balance compared to other countries. All of these seem to reflect the structural factors of Korea’s FX swap market, e.g., the existence of a risk premium for the Korean won, high reliance on FX funding from the foreign bank branches, the long-standing practice of Korean exporters’ asymmetric hedging behavior, off-shore NDF trading by non-residents, etc.

Several pieces of literature on the cause of the swap market imbalance argue that the deviation from covered interest rate parity stems from the transaction costs, risk premiums, and financing capabilities. This study tackles the disequilibrium between supply and demand in the FX swap market as a key element of the imbalance, considering that the liquidity condition between the foreign exchange market and the FX swap market may differ.

The empirical results using daily data show that external factors such as global liquidity, volatility, and sovereign credit rating have a significant impact on Korea’s swap market imbalance. By contrast, in developed countries such as European countries and Japan, a shortage of global liquidity abates the swap market imbalance. The volatility index shows positive (+) signs and is statistically significant in most countries studied like Korea. Empirical analyses using monthly data also reveal results consistent to those from the daily data: Korea’s swap market imbalance increases as external uncertainties rise. Notably, the imbalance is confirmed to be attributable to Korean exporters’ persistent forward selling for the purpose of hedging and also to the increase in non-residents’ NDF trading. The study also finds that Korean investors’ increasing investments in overseas securities serve as a factor that increases demand for foreign currency in the FX swap market, while the coefficient for banks’ overseas borrowings is statistically insignificant.

It is obvious that the global crisis dummy deteriorates Korea’s swap market imbalance. However, the dummy variable indicating the period of Korea’s introduction of FX derivatives position limit since 2010 is a negative (-) and statistically significant, implying that active arbitrage transactions since then have reduced the swap market imbalance.

The analysis on the causal relationship between exchange rates and FX swap rates reveals a recently increased interconnectedness between the two markets. The impulse-response analyses using the VAR model show that a change in the exchange rate has a positive (+) impact on the swap rates in the post-crisis era, implying that the movements of the exchange rate and swap rate reflect the respective liquidity conditions. The impact of swap rates on exchange rates shows negative swings, suggesting that the rising demand in the FX swap market translates into upward pressure on exchange rates. This implies that a liquidity shortage in the FX swap market may spread into the exchange rate.

From the aforementioned analyses, the following policy implications can be suggested. First, it is critical to sustain sound economic fundamentals and sovereign credit rating to maintain the stability of the FX swap market. Second, it is necessary to improve and further develop the macro-prudential measures such as FX derivatives position limit because those measures seem to have contributed to restore equilibrium of the FX swap market. Third, considering the growing influence of the swap market on exchange rates and the interconnectedness between the two markets, addressing the swap market imbalance helps to stabilize the foreign exchange market. In particular, the discrepancy of the liquidity condition for the two markets should be closely monitored. Fourth, efforts to solve structural problems in the FX market should continue. To that end, it is important to curtail heavy reliance on foreign exchange funding mostly from the foreign bank branches and diversify the funding channel by internationalizing financial institutions’ business and increasing the convertibility of the Korean won in the long run.