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The Bank of Korea (BOK), effective from 25 July, has prohibited local and foreign financial institutions in Korea from buying foreign currency-denominated bonds issued for domestic use by Korean companies as a measure to limit external debt.
We believe this measure should help curb external debt, but will likely result in Korean firms paying higher borrowing costs as a consequence. Our FX/rate strategy team sees no material impact on the Korean won (KRW) or Korea Treasury Bonds (KTB).
This measure was largely expected, as the government previously referenced it after South Korea’s short-term external debt rose sharply by $11.7 billion in the first quarter of 2011, to $146.7 billion.
Korean companies issued “kimchi bonds” (foreign currency-denominated bonds, the proceeds of which are mostly used locally) aggressively in the first quarter, then net issuance declined slightly in the second quarter.
Foreign bank branches in Korea are currently the largest holders of kimchi bonds, accounting for 77 percent of total.
Since foreign bank branches borrow from abroad to invest in kimchi bonds, Korea’s external debt, including branches of foreign banks as they are considered residents in the statistics, increases accordingly.
Kimchi bonds are attractive for both Korean issuers who can pay lower borrowing costs than KRW denominated bond issuance and foreign investors who can earn higher returns versus other overseas FX assets.
Since July 2010, Korea introduced a series of capital flow management measures, so called “capital controls,” to limit its external debt, given the widening interest rate differential between KRW and FX borrowings.
For example, Korea set a limit on FX derivatives ― initially 250 percent of capital for foreign bank branches and tightened to 200 percent now ― to prevent companies from borrowing FX denominated bank loans for local projects, reintroduced a withholding tax on KTBs or MSBs by foreign investors, and plans to impose bank levies on short-term external borrowings in August.
We expect this new regulation on kimchi bonds will help curb external debt, but closing this loophole will likely increase Korean firms’ borrowing costs.
As a result, the credit spread between corporate bonds and government bonds could widen, depending on the size of new KRW local corporate bond issuance.
Regarding the potential impact on KRW, Wee Choon Teo in our Asia FX strategy team views this as minor form of capital control, which will have a minimal direct impact on the dollar/won.
According to the BOK, about two-thirds of the $3.6 billion in kimchi bonds issued in the first quarter were issued for local use. This worked out to be an average of $42 million per trading day in the first quarter, compared with average daily dollar/won spot trading volume of $8 to $10 billion. The trade balance surplus amounted to $7.4 billion over the same period.
Advin Pagtakhan in our Asia rates strategy team sees minimal impact on the KTBs. The impact will likely be more visible in the cross currency swap rate, as the demand to swap FX into KRW should fall, resulting in a lower won/dollar cross currency swap.
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