By Michael Hellbeck

Korea dealt with two major Foreign Exchange shocks, the 1997/1998 Asian Financial Crisis, and after the Lehman Brothers’ collapse in September 2008. Both were triggered by abrupt and massive outflow of capital, leading to sudden currency depreciation and a drop in foreign reserves.

Capital flows surge greatly during economic boom periods and go into reverse during economic slowdowns or crises in other parts of the world. It leads to global banks’ balance sheet de-leveraging and a collective flight to safe assets, as we experienced again this year in August, when global fund investors withdrew portfolio investments from Korea. Capital inflow brings great benefits but also pose risks and dilemmas.

During the last two years, emerging market economies have had to deal with increased capital flow volatility, as the quantitative easing policies in developed countries have led to massive inflows back into emerging markets. Korea has witnessed a sharp increase in portfolio investments from overseas investors during the last 10 years.

While the foreign investors’ shareholding ratio in the Korean stock market reduced from a historic high of over 40 percent in 2004 to a current level of around 31 percent, the absolute foreign investor participation value in terms of market capitalization surged from $165 billion to now $331 billion.

Foreign investment in Korean bonds increased from 0.3 percent in 2003 to now 7.3 percent, amounting to $78 billion. Foreign Direct Investment, considered a long-term and stable capital inflow, has been less pronounced. The surge of foreign capital into Korea after March 2009 has led to sharp rise in the Korean stock market index, appreciation of the Korean won and lower yields in Korean government bonds, essentially creating a bull market in the FX, Equities and Bonds asset classes.

The Government introduced since January 2010 a series of macro-prudential measures which are aimed at reducing the speculative demand for foreign exchange while curtailing so-called “hot-money” inflows into the country. They started with a return to the “real-demand” driven foreign currency hedging principle in January 2010, as a result of which corporate clients can only enter into foreign currency hedge transactions if they provide the bank with evidence documents.

Regulations on foreign currency loans were tightened as well limiting their use to payments for imports of goods and services. In October 2011, the Korean government ramped up its currency swap lines with Japan and China to $70 billion and $60 billion, respectively.

These swap lines are meant to work as a financial safety net, deterring any potential speculative attack against the Korean Won. It was a smart move to re-instate these currency swap lines at a time when Korea does not need them and thus be prepared for any new financial turmoil created by factors outside the control of Korea.

Korea now has ample ammunition to deter an attack on its currency. With Korea’s external debt having reached $398 billion as of the end of June 2011, these are now fully covered by foreign reserves and currency swap lines.

There is a growing consensus that, over the long run, we must seek to develop the foreign exchange markets to ensure that exchange rates do not fluctuate greatly over short periods of time due to sharp swings in capital flows.

Korea’s FX market today, with a daily average FX spot turnover of $7-8 billion only, is too thin and illiquid to absorb any external shocks resulting from sudden withdrawal of foreign investments in the portfolio securities area.

According to the Bank for International Settlement, Korea’s share in the global daily FX trading turnover was only 1.5 percent in 2010 much less than Australian Dollar (7.6 percent) or Canadian Dollar (5.3 percent), which seems disproportionate to the size of Korea’s economy that is very much driven by international trade. In a way, capital flows around the world are like oceanic tides: in deep bays, tidal movements are little noticed, but in shallow bays the ebb and flow of the global ocean create huge effects.

We still remain vulnerable to external shocks and the measures taken have also led to the build-up of a huge offshore market in Korean won/USD Non-Deliverable Forwards (NDF). Korea today has the largest offshore NDF market in the world which is not something we should be proud about. The Korean Won is not yet a fully convertible currency.

Global portfolio investors including mutual funds sometimes withdraw from the Korean market because they classify and trade Korean stocks as an Asian Emerging Market investment. Relatively higher volatility in Korea’s financial markets is also partly due to the low level of long-term institutional investors, who only account for 14 percent of market cap (KOSPI), as compared to some 84 percent in U.S., 72 percent in Australia and 30 percent in Japan. It is, however, encouraging to see that the number of foreign pension funds, which are typically long-term investors, active on the Korea Exchange has risen from 766 in 2001 to 1,794 in 2010.

Once the current challenges emanating from the eurozone crisis are dissipating, further study should be undertaken to globalize Korea’s Foreign Exchange System through gradual removal of the FX restrictions, introduction of an offshore settlement of the Korean Won and ultimately full convertibility of the Korean won.

This will require the establishment of a road-map for foreign exchange development and a leap of faith, based on the belief that a deep and liquid foreign exchange market, coupled with incentives for attracting long-term foreign capital, will act as a superior shock absorber in the event of sudden capital reversals. The original blue-print for the liberalization of the foreign exchange market, drafted by the Government in 2003, envisaged full liberalization by 2011.