[Foreign Exchange Structure Reform] Expectations for Exchange Rate Stability and MSCI Index Inclusion... Concerns Over Expanding Market Instability

It is expected that the stability of the exchange rate will improve once the 'Foreign Exchange Market Structure Improvement Plan' is fully implemented next year. As the number of financial companies participating in the domestic foreign exchange market increases and the volume of won transactions grows, exchange rate volatility may be somewhat alleviated. Additionally, with the expansion of foreign exchange market openness, inclusion in the Morgan Stanley Capital International (MSCI) developed markets index, which helps resolve the 'Korea Discount' (undervaluation of the Korean stock market), is also expected to gain momentum.

However, some voices express concerns that the participation of foreign financial companies could weaken the competitiveness of domestic financial companies and increase market instability due to the expansion of speculative trading. While the system could benefit the Korean economy if well established, given the significant market impact of the reform, it should be pursued cautiously with consideration of potential side effects.

Expectations for 'Exchange Rate Stability' through Foreign Exchange Market Openness

According to the Bank of Korea and the Ministry of Economy and Finance, foreign exchange authorities anticipate that if the structural improvement work, centered on opening the domestic foreign exchange market and extending trading hours in the second half of next year, materializes, the exchange rate will also stabilize. Song Dae-geun, head of the Bank of Korea's foreign exchange operations department, said, "If the structure of the foreign exchange market improves, interest in won assets offshore will increase, leading to greater domestic investment demand. As more market participants join, the exchange rate is expected to show a more stable pattern."

The foreign exchange authorities also expect that opening the domestic foreign exchange market will absorb offshore Non-Deliverable Forward (NDF) transactions, thereby reducing speculative pressure originating from abroad. Until now, the domestic foreign exchange market has been operated in a closed manner, causing the offshore NDF market to grow abnormally large, and since the 2010s, NDF transactions have even surpassed spot foreign exchange transactions. As a result, upward pressure on the exchange rate (the "tail") caused by offshore speculative forces has frequently shaken the Seoul foreign exchange market (the "body"). The Bank of Korea explained, "Due to strengthened global regulations after the financial crisis, NDF transaction costs have increased, and overseas investors prefer to trade directly in the domestic market rather than the NDF market," adding, "The domestic market can sufficiently absorb NDF transactions."

Positive Effects on MSCI Developed Markets Index Inclusion

The government expects this measure to have a positive impact on inclusion in the MSCI developed markets index. MSCI refers to a type of global stock index published by MSCI Barra, a U.S. company that is the largest shareholder of Morgan Stanley. Markets are classified by country characteristics into 'developed markets,' 'emerging markets,' and 'frontier markets,' with Korea currently classified as an emerging market. Since 2008, Korea has attempted to be included in the developed markets category but has repeatedly failed due to institutional and structural issues such as the absence of an offshore foreign exchange market, lack of English-language materials, and mandatory registration for foreign investors.

Inclusion in the developed markets category of the MSCI index brings the advantage of attracting funds with higher stability than speculative capital. Overseas pension funds and large funds often invest according to MSCI's developed markets index, and the funds they manage are generally large in scale and have a long-term investment nature. Conversely, emerging markets tend to attract speculative capital seeking high returns. Goldman Sachs also released an Asia portfolio strategy report last year, forecasting that $44 billion could flow into Korea upon MSCI inclusion.

The foreign exchange market reform opens new business opportunities for domestic financial companies, as they will be able to attract won transaction customers abroad. The government has already introduced the Won Forward Bank system to expand overseas business for domestic financial companies and selects six domestic commercial banks annually. Kim Seong-wook, director of international economic management at the Ministry of Economy and Finance, explained, "Domestic financial companies can use the changed market system as an opportunity to expand their global overseas operations."

Concerns over Side Effects of Market Opening... Authorities to "Strengthen Supervision"

However, since this is effectively the first time opening the foreign exchange market since the foreign exchange crisis, concerns are significant. Unlike other countries, Korea bears deep scars from the 1997 IMF foreign exchange crisis and has weaker competitiveness compared to the U.S., Japan, and China. A smaller economy means that when an offshore foreign exchange market is established, the government's response to sudden exchange rate fluctuations is weaker, which is a disadvantage. Especially in Korea's case, the high export dependence makes it vulnerable to exchange rate volatility, and the resulting side effects are substantial. If full 24-hour opening is pursued in the future, the impact on the domestic stock market, which has relatively fewer regulations on foreigners, cannot be ignored.

To prevent such problems, the government plans to strengthen the monitoring level of foreign financial institutions (RFI) located overseas to the same extent as domestic institutions. In particular, separate management of RFIs' forward foreign exchange position ratios, apart from existing regulations, is also being considered. If an institution participates in the foreign exchange market but fails to meet requirements or properly report, measures such as temporary suspension of business or license revocation are expected to be implemented. Furthermore, foreign exchange authorities plan to establish a cooperative system with local supervisory authorities to notify related matters and conduct direct or delegated audits in cases of illegal transactions or violations of reporting obligations.