By Michael Hellbeck
During the third quarter of this year, there have been mounting concerns about a global tightening of U.S. dollar liquidity resulting from the European sovereign debt crisis and North East Asian markets looked vulnerable to this global dynamic, despite having a solvent and stable financial system. The impact to Korea has been surprisingly benign, which prompted me to take a closer look into the Foreign Currency Debt and Liquidity position of the Korean financial system.
The central bank’s foreign exchange (FX) reserves of $ 303 billion up from $201 billion at the end of 2008 are now more than twice the size of short-term external debt which came down to $139 billion in the third quarter,2011. Central banks’ FX reserves are an important factor for assessing a country’s FX liquidity risks. During an FX credit crunch period, a central bank with sufficient FX reserves could provide dollar liquidity into the system, preventing a country from falling into a FX crisis.
In addition, The Bank of Korea has U.S. dollars about $130 billion worth of FX swap lines with Japan and China, adding extra comfort as they act as a kind of financial safety net, in case of an FX crisis, as last seen in 2008 following the Lehman collapse. During 2008, Korea witnessed a capital outflow of $57 billion due to sudden reduction in lending and portfolio investments by foreign investors, which caused the won to depreciate sharply against the U.S. dollar, at least temporarily.
At that time, Korea managed to weather the storm relatively well due to its high FX reserves, augmented by FX swap lines with the U.S., Japan and China, and its liquidity support to the Korean banks. Since then, the regulators imposed a series of more stringent FX regulations aimed at improving the Korean banks’ FX position and restricting banks’ FX derivatives positions, which were seen as a key reason for borrowing short-term external debt.
Compared with the 2008 global crisis period, Korea’s external debt has declined meaningfully to $139 billion from a peak of $190 billion. Korean banks lowered their short-term external debt by 15percent from its 2008 peak to $56 billion whereas foreign banks cut their short-term external debt by more than 50 percent from its historic high in 2008 of $94 billion to now $47 billion.
During the third quarter, 2011 alone, the foreign bank borrowings dropped by a substantial $17.2 billion, which could be evidence of asset-repatriation by some European banks that have been faced with the need to shrink their balance sheets to boost their capital ratios.
In contrast to the sudden capital outflows unfolding after the Lehman crisis in fourth quarter,2008, the outflows in 2011 have been less pronounced and less sudden. The Eurozone crisis was described by an economist as an “accident in slow motion” which has given the market time to take precautionary measures. Note that Korea’s total external debt from the EU banks excluding UK amounts to $87 billion as of second quarter,-2011.
Korea’s financial system today is much better prepared to deal with any sudden capital outflows. The Korean banking system’s balance and maturities of FX assets and liabilities are now largely matched, in contrast with the 1997 Asian crisis, at which time Korean banks had sizable currency and maturity mismatches, funding long-term U.S. dollar denominated loans with short-term dollar borrowings.
Currency and maturity matching theoretically eliminates FX exchange risks, FX interest rate risks and FX liquidity risks. Despite all the pre-emptive steps taken by Korean authorities since 2008, a disorderly sovereign default in the eurozone area could still trigger a powerful de-leveraging dynamic globally and risk aversion dynamics similar to those of the 2008-2009 crisis.