By Tim Condon

The Korean won is no longer a VIX (Volatility Index) currency. This is a temporary condition arising from weak domestic demand. It will end when the next credit cycle heats up.

We have long considered the won to be Asia’s VIX currency. The VIX measures implied volatility of the S&P 500 stock index. It is known as the fear index because it spikes during financial market panics. The won is Asia’s VIX currency because of its tendency to underperform _ depreciate more against the U.S. dollar ― its Asian neighbours during periods of “risk-off” investor sentiment and outperform during “risk-on” periods.

The won is Asia’s VIX currency despite Korea having the world’s seventh-largest foreign reserve holdings. This appears to violate the Guidotti Rule, which holds that having foreign reserves equivalent to short-term external debt immunizes an economy from a balance of payments (BOP) crisis.

Korea’s foreign reserves were equivalent to 2.3 times short-term external debt in 2011, up from 2.1 in 2010 and up from a pre-global financial crisis low of 1.3. Taiwan, which we consider immune to a BOP crisis, has had a Guidotti rule ratio of between 3 and 5 for the last decade (3.6 in 2011). For Korea this would require increasing foreign reserves by 60 percent to over $500 billion.

The won became Asia’s VIX currency by dint of its history. What stand out in a long-term chart of the won-dollar exchange rate are the episodic maxi-devaluations followed by multi-year periods when the won is a one-way bet. One-way bets are attractive to speculators. Hot money positioning for won appreciation is the quantity primal whose price dual is the won’s status as a VIX currency.

Short-term external borrowing has been a principal channel through which hot money flowed into Korea. Since 2009 Korea’s financial regulators have introduced numerous macroprudential policies aimed among other things at discouraging banks from borrowing short term. Recently released external debt data for 2011 indicate some success. Total external debt increased $38.9 billion in 2011 to $398.4 billion. But all the increase was in long-term debt. Short-term debt contracted $3.6 billion to $136.1 billion.

Less short-term external borrowing means fewer hot money inflows. The won becomes less of a VIX currency. This raises an interesting question. In its 2011 report on Korea, the IMF prescribed greater two-way exchange rate risk “that eliminates the perceived one-way bet on the currency” as a means of discouraging hot money inflows. The authorities in Indonesia and the Philippines have opted for this approach and we think it has worked.

Has Korea successfully substituted macroprudential policies for greater two-way exchange rate risk to deter hot money? We doubt it. Since 1995 banks have been responsible for about 80 percent of short-term external borrowing.

Banks fund asset growth in the capital market including the offshore market when their deposit bases are stretched. Korean banks’ loan-to-deposit (LDR) ratio fell from a pre-global financial crisis peak of 125 percent to about 105 percent in early 2010 where it has remained (we calculate the LDR as commercial and specialized banks’ corporate and household loans in relation to the sum of demand deposits, time and saving deposits and CDs or certificates of deposits).

The global financial crisis and the subsequent weak recovery of domestic demand, not the macroprudential policies, are responsible for the fall in banks’ LDR.

The macroprudential policies have shifted external borrowing toward long term from short term. However, we don’t think balance of payments row labels like “short-term” or “long-term” say anything about vulnerability to balance of payments pressure.

We think what matters is the growth of external debt. If the growth of Korean banks’ external debt accelerates to the 34 percent it averaged in the three years before the crisis ― growth in 2011 was 12 percent ― we think the won would be revealed to still be a VIX currency.

The good news is that after the wild swings before and after the crisis, bank loan and deposit growth have settled in a 7-8 percent range. As long as this persists banks will continue to finance a portion of loan growth with external borrowing, the macroprudential policies will continue to favour borrowing long term and the won’s VIX currency status will be on hold. It will return when the next credit cycle heats up.