By Kwon Young-sun

Monetary policy can have an impact on domestic demand through two main channels. The first is the interest rate channel: interest rates at long maturities are partly driven by unanticipated changes in short-term rates, which are tightly aligned to policy rates.

This effect on long-term rates is important as investment and consumption demand is often more responsive to long-term rather than short-term rates. The second is the exchange rate channel: changes in policy rates affect the interest rate differential between the local currency and others, which influences the Korean won (KRW).

For a small, open, financially integrated, capital market-dominated economy like Korea’s, which is unable to influence global financial conditions, financial globalization should weaken the interest rate channel. As we see in recent bond markets in the region, Asian central banks are able to control short rates almost completely, but cannot control long-term rates as tightly. This suggests that current and expected U.S. policy rates in regard to the U.S. growth/inflation outlook can be more important for Korea and Asia’s long-term rates than Korean and Asian policy rates.

It is true that, if the domestic financial system is dominated by banks, notably in China and long-term bond markets are not well developed, then short-term rates are more important than long-term rates as firms and households use banks as their main source for funding.

In Korea, small and medium-sized enterprises (SMEs) and consumers certainly use banks, but the economy’s key growth drivers are large export-orientated conglomerates, which depend more on the capital markets, both local and overseas, than they do on the banks. In fact, only Korea and Malaysia have more outstanding local currency bonds than banks do loans, while in other Asian countries the financial systems are largely dominated by the banks.

Monetary policy in Korea should be able to utilize the exchange rate channel to deliver inflation targets and macro-economic stability. In practice, the FX market could exhibit excess volatility and may diverge from fundamentals for lengthy periods. The existence of carry trades involves the belief that interest rate differentials are not fully compensated for by exchange rate movements. For instance, uncovered interest rate parity does not hold. In this regard, the exchange rate can be both a tool for stabilization and a source of shocks.

Given that financial globalization is providing the instruments to reduce KRW volatility ― either, hedging or arbitrage trading, we believe that policymakers will promote further deepening of the financial capital markets in an effort to limit KRW volatility and stabilize the macro economy. Indeed, during the most recent global market sell-off in August-September 2011, there were sizable net capital outflows in the stock market but net capital inflows into Korean bond markets. This suggests that a well-diversified foreign investor base contributed to reduce the volatility of capital flows.

In this regard, we judge that further developments in Korea’s local currency bond markets will ultimately help Korea’s financial stability and economy, if sound macro, fiscal and prudential regulation policies are implemented. A local-currency, long-term bond market can reduce currency mismatches and the concentration of credit and maturity risks in the banking system.

Before the 1997 Asian crisis, Korean firms relied heavily on FX denominated long-term bank loans for their massive capex investments. To respond to this demand, Korean banks borrowed sizable short-term external debt, which resulted in a massive currency/duration mismatch in the Korean banking system. The lack of a long-term local-currency debt market could lead to greater volatility from capital flows as the flow of foreign capital may concentrate on short-term paper.